Michael Tennenbaum's Interview on Distressed Debt

In an interview on Bloomberg News, Michael Tennenbaum, founder of Tennenbaum Capital Partners, presented his thoughts on the current state of the distressed debt market. (Interview video embedded below). In addition, Bloomberg held it's Dealmaker's Summit, which I will also report on later today / tomorrow (lots of fantastic speakers)

Here are some of my thoughts / biggest take-aways from the interview:
  • Talks about the 1.2 trillion of debt coming due over the next five years (200 billion due in the next two years). With so much of that in lower rated credits, thinks default cycle will pick up - something I am very much in agreement on.
  • Distressed debt for control is complex and thus less competition and thus better entry valuation points - something Seth Klarman has discussed repeatedly as it related to distressed debt
  • Points out that Tennenbaum is a "rescuer, not a shark." Tennenbaum historically has been very active in the DIP space - a space that is getting very crowded right now.
  • B rated issued default at a 15% cumulative rate over 3 years. Lots of B rated issue now and last year. More opportunities coming down the pipe.
  • Interviewer correctly notes that the overall credit market's gain is really not the best thing for distressed debt investors - Not exactly right: A healthy credit market means easier exit facility financings and generally higher valuations on exits if that sort of thing is the way you will play a particular case (see: Six Flags).
  • Tennenbaum notes that middle market issuers are having issues coming to market. What about all the funds whose sole purpose is to do that sort of thing? Highbridge for instance has a fund whose main purpose is lending to middle market issuers. That being said - that has been a GREAT business to be in the last year.
  • Outlook for economy: Poor - no real drivers. Muddle along as John Mauldin would say.
Overall great interview. I have worked alongside and across the table from the guys at Tennenbaum Capital - incredibly smart group of people. Will try to post more on them in the future.


A Fantastic Distressed Debt in Institutional Investor

Here is a fantastic distressed debt article that was sent to me earlier today. I have copied and pasted both below (sorry for the length) - My comments will be in a post later tonight (in addition to my notes on Michael Tennenbaum's interview on Distressed Debt)

Distressed-Debt Investing Shows Great Promise

(Article can be found here: II Article on Distressed Debt)

By: Xiang Ji
September 2010

When Centerbridge Partners, a New York–based private equity and distressed-debt investor, gained the right this spring to sponsor the reorganization of bankrupt Extended Stay Hotels, it was more than just a corporate coup. For Centerbridge managing directors Vivek Melwani and William Rahm, it was a personal triumph. For close to two years, Melwani, 38, at one time a bankruptcy lawyer, and Rahm, 31, formerly a private equity specialist for Blackstone Group, had been painstakingly combing through the convoluted debt of the 684-hotel, Spartanburg, South Carolina, chain.

“Extended Stay had a $4.1 billion mortgage that was securitized and sliced into 18 tranches, along with $3.3 billion of mezzanine debt divided into ten separate loans,” recalls Rahm with a shudder. Some prospective investors in the efficiency-hotel company had thrown up their hands after discovering what a mishmash its finances were — a situation exacerbated by the fact that this was the first-ever large-scale corporate bankruptcy involving commercial-mortgage-backed securities, and therefore posed extra uncertainty. (The numerous holders of CMBSs are presumably harder to round up to vote on a rescue plan than a smattering of banks holding shares of a mortgage.)

Yet Centerbridge saw opportunity buried beneath the complexity. “Based on our analysis, we recognized that there was a very good business here struggling under too much debt in a complicated structure,” says Rahm. Extended Stay had good management and a low-cost business model that produced high margins but was saddled with a bubble-era balance sheet, he explains.

Unfortunately for Centerbridge, other private equity operators and distressed-debt investors were arriving at the same conclusion. Thus, when Centerbridge, at Melwani and Rahm’s recommendation, bought a big chunk of Extended Stay’s CMBSs at a sizable discount in late 2008, other investors swooped in too. And when Centerbridge and New York hedge fund firm Paulson & Co. put up $450 million in February 2010 in a partial bid intended to give them effective control over Extended Stay’s reorganization (and which valued the company at about $3.3 billion), the offer was topped less than one month later by real estate mogul and glamour-hotel impresario Barry Sternlicht. His Greenwich, Connecticut–based Starwood Capital Group paired up with Fort Worth,Texas–based private equity giant TPG Capital in March to pony up $905 million in sundry forms (cash, a backstop rights offering and cash alternatives).

Centerbridge matched Starwood’s offer and sweetened it by agreeing to forgo the breakup fee and other expenses that it would ordinarily be entitled to as a stalking-horse bidder: the one that gets a corporate auction going by creating a floor price. Moreover, Centerbridge demanded that an open auction be held before long so that one of the investor groups could be picked to implement a reorganization plan to try to salvage the long-suffering Extended Stay.

So after 19 straight hours of bidding and counterbidding, Centerbridge, Paulson and a third partner, Blackstone, declared victory in the wee hours of Thursday, May 28. Their offer of $3.925 billion topped the Starwood group’s bid by just $40 million. The bidding war pushed up the value of Extended Stay by roughly $625 million. Thrilled at winning the auction, Melwani and Rahm assert that Centerbridge got a great price, especially considering that the firm’s holdings of cheap Extended Stay CMBSs will be paid back at 100 cents on the dollar.

For distressed-debt investors, the epic contest for Extended Stay is both good and bad news — a combination with which they are intimately familiar. On the positive side, it demonstrates that an industry not long ago written off as half dead is registering fresh vital signs. On the negative side, the sheer impenetrability of Extended Stay’s finances and the fierce bidding for the insolvent company attest both to the unprecedented complexity of distressed-debt investing today and the intense competition for deals.

Distressed-debt investors say that, compared with the high-yield bond market’s collapse in the early ’90s or the stock market bubble’s bursting a decade later, the recent financial crisis is characterized by considerably more-recondite corporate reorganizations. Creditors of Lehman Brothers Holdings, for example, are divided into more than 100 classes, each with what seems to be a different repayment priority. The freewheeling financial creativity of the past decade has added to the complications of many workouts.

The ferocious rivalry for deals, meanwhile, is in large part merely a function of overcrowding. In the downturn of the early 2000s, some $30 billion of capital was committed to distressed debt, according to Chicago-based data provider Hedge Fund Research. One expert on the subject, New York University Leonard N. Stern School of Business professor Edward Altman, gauges the sum at $300 billion today. The field is awash in deep-pocketed new entrants, such as Blackstone, KKR & Co., Paulson and Tudor Investment Corp.

“There is an awful lot of money chasing too few opportunities,” contends Jeffry Haber, controller of the $558 million Commonwealth Fund, a New York–based private foundation. “People might pitch buying debt at 60 cents on the dollar. Then you see them buying things at 90 cents.”

Howard Marks, co-founder and chairman of one of the largest and most venerable distressed-debt firms, $76 billion-in-assets Oaktree Capital Management, sees interlopers as the big problem. “A lot of money can swing into distressed debt that is not technically allocated to it,” he points out. “Warren Buffett can be the biggest distressed-debt buyer. Hedge funds can swing into distressed debt. Knowing how much money has been raised by pure distressed-debt funds is only half of the picture.”

Excessive demand aside, there’s also a supply-side issue. Some insist that as the economy recovers, albeit haltingly, the great bargains tossed up by the worst financial upheaval since the Great Depression are growing a little scarce. At the end of 2008, the distressed-debt ratio — the proportion of junk bonds trading at truly distressed levels (1,000 basis points or more above Treasuries) — peaked at 85 percent, according to Standard & Poor’s. By May the ratio had improved (or, from a distressed-debt investor’s perspective, worsened) all the way to 9.4 percent. At the same time, the high-yield default rate, having peaked at 13.5 percent last November, had eased to 5.4 percent in July, reports Moody’s Investors Service.

The upshot, many were contending this spring, is that the grave dancers’ ball is well and truly over. The 28 percent average return on distressed-debt investing in 2009 (according to HFR) will not be repeated for some time, they insist.

Yet many distressed-debt investors beg to differ. Doom-mongerers by nature, they see a world of troubles ahead — they’re hardly alone — and past surveys have amply captured this Cassandra streak. According to an annual poll last January by publisher Debtwire, while one third of distressed-debt investors believed corporate restructurings had peaked, two thirds didn’t expect that to happen until this year, 2011 or even beyond.

“The fact is that over $1 trillion of bank loans and junk bonds are maturing over the next five years, and given the number of companies that are leveraged north of 5 times, the supply of overleveraged credit is as large as it has ever been,” contends Anthony Ressler, co-founder and senior partner of Los Angeles–based alternative-investments outfit Ares Management.

Jonathan Lavine, chief investment officer of Sankaty Advisors, the credit affiliate of private investment manager Bain Capital, adds: “We simply need to be patient. Our analysis on the ‘maturity wall’ suggests that the opportunity is significant — about 15 to 20 percent of maturing debt is potentially going to need to be restructured, which would be three times more than the last cycle.”

Credit Suisse was estimating in mid-July that about $985 billion of high-yield bonds and leveraged loans will mature between 2011 and 2014. That’s somewhat less than the bank’s December 2008 estimate of $1.2 trillion — reflecting a rush of refinancing — but it’s still a staggering figure. What’s more, the gloom-sayers gleefully note, the average annual default rate on U.S. speculative-grade corporate debt remained below 2 percent from 2005 through 2007 — a condition unseen in the 30 years before that. Implication: A slew of defaults are ready to erupt. On top of all that, the past three years witnessed a record $436 billion in high-yield U.S. bond issues.

“We see the default rate as a W pattern” with the slanted vertical on the right extending into the future, says Centerbridge co-founder Jeffrey Aronson. He figures that many overleveraged buyouts will hit snags and come asunder. “Amend and extend” deals merely delayed the underlying companies’ day of reckoning with an unsustainable debt load, Aronson asserts. He points out too that some buyouts during the precrash boom years relied on floating-rate loans and that the companies involved will be squeezed all the harder when rates eventually rise from their current record low. But he adds that overall, “it’s much more situational today in distressed debt — you have to do the work and focus on special situations.”

Gloom is apparently everywhere, though, if you look eagerly enough for it. High-yield bond issuance globally reached $178.9 billion last year, only 7 percent below 2006’s record volume. And these latest, postcrash bonds carry tighter covenants, meaning companies won’t find it so easy to slither through loopholes to avoid formal default. Jitters about European sovereign debt are a reminder that the global economy is not out of the Bretton Woods yet. Small wonder that the more optimistically pessimistic distressed-debt investors foresee returns this year ranging from the high teens to 20 percent.

“This is a better time than a year ago for distressed debt,” declares WL Ross & Co.’s Wilbur Ross Jr., a doyen of investing in ailing companies and whole industries. He notes that “we have a pillow somewhere that says, ‘Don’t buy anything you can buy off a Bloomberg screen.’” Ross is looking in particular at financial institutions. “Around 500 banks will fail before we are out of this mess,” he says.

That kind of encouraging news (depending on one’s perspective) resonates with Marc Lasry, co-founder and CEO of New York–based, $18 billion-in-assets Avenue Capital Group. “I’m more optimistic because there are more problems out there,” he says. “The economy is not growing as fast as people had hoped. There’s a significant amount of debt and less capital available. You could end up having a lot of restructuring as companies choose to work with creditors to avoid bankruptcy. This could be a perfect storm, and that is great for distressed-debt investors like us.” From its inception in 2007 through March 31, Avenue’s nearly $17 billion Special Situations Fund V has run up a net annual internal rate of return of 11.6 percent.

But no matter whether they see Armageddon coming or merely bad times, or if they differ on which targets will be the ripest in the approaching disaster, distressed-debt investors agree on one thing: They are going to have to labor harder than they did in 2009 to bring home alpha. One area a number of firms are looking at closely is the sometimes neglected middle market, usually defined by distressed-debt investors as companies with ebitda (earnings before interest, taxes, depreciation and amortization) of anywhere from $10 million to $100 million. Close to $300 billion of middle-market debt is due to mature between now and the end of 2014, according to S&P. Moreover, these credits haven’t recovered in price to anywhere near the debts of large-capitalization companies. In July the spread between the loans of middle-market and large-cap companies was on average 300 basis points, compared with about 80 basis points historically.

“We expect middle-market companies with enterprise values ranging from $200 million to $800 million to remain underserved by middle-market lenders for several years to come,” says Michael Parks, head of distressed funds at Los Angeles asset manager Crescent Capital Group. “These companies tend to be less followed by Wall Street research, less liquid and undercapitalized.” Parks’s fund ordinarily invests $20 million to $30 million apiece in middle-market companies.

In a typical such exercise, Crescent spent more than $30 million between 2003 and 2006 buying up the debt of Brown Jordan International, a Florida maker of snazzy outdoor furniture. Plagued by mismanagement and overleveraged, the company wound up undergoing an out-of-court restructuring in 2007. Having gained 30 percent of the reorganized Brown Jordan, Crescent led a turnaround that saw ebitda go from $12 million in 2004 to $43 million in 2008.

“Everybody wants to do the big-name bankruptcies because they are liquid and you can invest a lot of cash, but there are only a handful of megadeals,” notes another middle-market enthusiast, Thomas Fuller, senior managing director of alternative-invesment specialists Angelo, Gordon & Co. in New York.“So what we are focused on are companies that have between $500 million and $3 billion of debt.”

Killings at all target levels are becoming rarer. The 63-year-old Marks, interviewed in his sun-splashed 28th-floor office at Oaktree’s spalike LA headquarters (marble floors, California artwork, white roses), is characteristically guarded about the outlook. “You can’t find bargains like two years ago,” he cautions, adding: “That’s okay; we can still make good investments. We just have to accept lower returns in order to avoid increased risk.”

And work as hard as ever. “We will continue to try to find bargains by constantly doing analysis and through close relations with brokers and debtholders,” vows Marks. “It’s all execution, just like baseball.”

Oaktree’s conservative investment stance has seen it through challenging times before. Founded in 1995, the firm has outlasted such potentially formidable rivals in the distressed-debt arena as Fidelity Investments; Goldman, Sachs & Co.; and T. Rowe Price Group. All three launched serious distressed-debt operations only to abandon them because of conflicts of interest or other concerns.

Oaktree’s working motto, in Marks’s words, is, “If we avoid the losers, the winners will take care of themselves.” He explains that the goal is to “match market returns in good times and do markedly better in bad times.”

For that, one needs strict discipline. During the 2004-’06 credit boom, when the default rate stayed below 2 percent, Oaktree did not raise a batch of money, as tempting as that would have been in a giddy market. Nor did it deploy all the funds at its disposal. “Oaktree only invested half of the money we committed,” confides one institutional investor client. “When the opportunities are not there, they don’t do deals.”

That defensive approach has resulted in pretty reliable performance, though Oaktree naturally fares better when companies do worse and defaults are abundant. The firm’s OCM Opportunities Fund IVb, whose strategy is to “influence” distressed debt (that is, it does not aim to take actual control of companies), was raised in 2002, when memories of the tech bubble bursting were still fresh, and through June had a net IRR of 46.5 percent. By contrast, OCM Opportunities Fund III, raised two years earlier during happier times, had a more modest IRR of 11.9 percent.

Recent results have been robust. About the time the U.S. stock market peaked precrash, Oaktree raised its largest-ever distressed-debt fund — the $10.9 billion OCM Opportunities Fund VIIb — and the firm invested it aggressively during volatile 2008 and 2009. From its inception in 2008 through June 30, the fund had a net IRR of 23.5 percent.

In February, Oaktree finished raising a $3.3 billion fund, OCM Principal Fund V, that will act as a principal in taking control of companies and forcibly extricating them from trouble. Marks says he wants to be prepared for opportunities in overleveraged buyouts and commercial real estate if the recovery stalls. However, he also wants to be well positioned in case the economy gets better on schedule. Over at $12 billion Centerbridge, the 51-year-old Aronson is cheered by the case for pessimism.

“Last year everyone could buy debt at maybe around 50 cents,” he says. “Today it may trade at 80 cents. So it must be over, some people think. In our view it is all about value versus price. The default rate will decline this year, but as this massive amount of buyout-related debt matures from 2011 to 2015, some of those companies will be refinanced; others will have to be restructured.” The result, he predicts, will be a default rate trending up smartly in 2011 and 2012. “The macro environment is quite fragile,” he notes.

That is halfway good news for Centerbridge. The reason is that this bipolar firm is virtually unique among distressed-debt shops in also doing substantial private equity investing as a way to smooth out returns — in theory, private equity should thrive in good economic cycles and distressed debt in bad.

“What is attractive about Centerbridge is its combination of buyout and distressed debt,” contends Jay Fewel, senior investment officer at Oregon’s Public Employees Retirement System, which manages $53 billion. “The firm can take advantage of whatever economic environment we are in.”

Consider Centerbridge’s hybrid approach to investing in Dana Holding Corp. When the Maumee, Ohio, auto-parts manufacturer filed for bankruptcy in 2006, Centerbridge was able to form an alliance with the United Auto Workers and United Steelworkers — a process helped, no doubt, by the firm’s in-house auto expert at the time, Stephen Girsky, once a special adviser to former GM CEO Rick Wagoner and since March the automaker’s vice chairman for corporate strategy and business development. (He was also the top-ranked automotive and auto-parts analyst in Institutional Investor’s All-America Research Team while at Morgan Stanley.) With the unions’ blessing, Centerbridge’s distressed-debt team negotiated a recapitalization with Dana’s creditors. The investment firm itself bought $250 million of the company’s convertible preferred shares, giving it sway in appointing directors; other debtors bought $500 million of the shares, which paid a 4 percent dividend.

Once Dana emerged from bankruptcy in February 2008, Centerbridge’s private equity specialists took over. Centerbridge co-founder Mark Gallogly and a managing director, David Trucano, were installed on Dana’s seven-member board. A Centerbridge turnaround expert, Brandt McKee, was brought in to cut costs and shore up the company’s capital structure. Dana’s ebitda profit margin has increased from 0.3 percent at the end of 2008 to 10 percent in this year’s second quarter. Once highly leveraged, the company now has $1.06 billion in cash versus $939 million in debt.

More than two years after Dana exited Chapter 11, Centerbridge still holds its original complement of convertible preferreds, which if converted would make it the company’s largest shareholder. And Dana’s shares have risen from $0.23 last year to $11 as of mid-August.

Founded in 2006, Centerbridge has prospered from its baptism by fire in the financial crisis. The firm’s $3.2 billion Capital Partners fund, which invests in both buyouts and distressed debt, has a net IRR of 21.5 percent from inception through March 31. And its $6.4 billion Credit Partners Fund, focusing on just distressed debt, returned 62.5 percent in 2009 after suffering a 23.2 percent loss in 2008. For this year through June, the fund’s IRR was 10.4 percent. Meanwhile, Centerbridge’s $2 billion Special Credit Partners Fund, which does nothing but buyouts, had an IRR of 76.5 percent from its inception in June 2009 through March 31. (All these numbers come from an investor in Centerbridge funds.)

Scanning the horizon for opportunities, Aronson fixes on commercial real estate. “Today there are hundreds of billions in commercial real estate debt on banks’ books, which they’re holding while hoping things will get better,” he observes. “But as banks heal themselves and build up equity cushions, eventually they will write down those loans and sell them” to distressed-debt investors like Centerbridge.

Distressed-debt investing requires patience even more than capital. “People come and go,” says Oaktree’s Marks. “For those people who raised funds in 2007, the best ones will survive and the worst ones will disappear.” Much like the companies in which they invest.



Distressed Debt Investing's Book Recommendation: Priceless

Readers of the site know I am a big fan of William Poundstone. In the investing community, Poundstone is probably most well known for his book: Fortune's Formula - which details the Kelly Formula which has also been talked about on this blog repeatedly (Kelly Formula Post).

William Poundstone is out with a new book entitled Priceless: The Myth of Fair Value (and How to Take Advantage of It). A long story short, I highly recommend this book. It is probably my favorite book, and most eye-opening, that I have read this year.

Priceless, in short, is about behavioral economics. Poundstone develops the history and birth of this new school of thought and how it affects each and every one of us in our daily lives. He draws on the research of some of the great thinkers in the field (Thaler, Kahneman, etc) and shows, basically, how crazy people are when it comes to money.

Why is this important to investors? MANY of the concepts laid out in the book affect professional investors day in and day out in their analysis of stocks and bonds. Concepts like loss aversion, anchoring, "greater fool" theory are presented in the book with numerous examples from behavioral experiments and research. On a daily basis, I see these biases and cognitive foibles played out in the pricing of stocks and bonds.

Here's an example: Did you ever notice that when an investor hears an earnings estimate from the sell side that their own estimate is probably already skewed? Just hearing the number: "I think earnings will come in around $5.00/share" can taint your analysis. Why? And this is what behavioral economics is about but human use shortcuts to get through their daily lives. As security analysts we need to do our bests to identify these biases and cognitive errors to better our and our investor's results.

I highly recommend this book to all those that want to better their judgement as it relates to the numbers that are so important to investing (will probably help you with things like grocery shopping and buying a car - "always throw out the first number"). For those interested in more reader, Fuller & Thaler Asset Management, a buy side shop that literally exploits these inefficiencies (and have done so very efficiently according to their results), has a number of articles and white papers on their site which I also found to be great reads.


David Tepper in New York Magazine

Jessica Pressler, a personal friend of mine, has an absolutely amazing article profiling David Tepper in this month's New York Magazine. And if you have not seen it, David Tepper was on CNBC last week with a fantastic (and often funny) interview with the guys from Squawk.

When I first joined the buy side, I joined a colleague at an event where David Tepper was one of the keynote speakers. Ever since then I have followed the moves of Appaloosa. The fund has always been active in the distressed space (situations they have recently played: WAMU, AIG sub debt, Delphi, GM, etc). In my opinion, David Tepper and Seth Klarman are the best money managers in the business right now.

My favorite quote:
“This company looks cheap, that company looks cheap, but the overall economy could completely screw it up,” he said grumpily. “The key is to wait. Sometimes the hardest thing to do is to do nothing.”
Again, a must read for all distressed debt investors.



Distressed Debt Investing Interviews Sandy Mayerson

A colleague at IQPC, which is running The Global Forum on Investing in Distressed Debt has interviewed Sandy Mayerson, a partner at of Squire Sanders & Dempsey. Sandra E. Mayerson has extensive experience in both debtor and creditor matters, and has represented creditors’ and bondholders’ committees, debtors in Chapter 11, banks and other secured creditors, unsecured creditors, investors in distressed situations and claims traders. Ms. Mayerson’s background spans both bankruptcy and securities law and is informed by years of experience in private practice as well as involvement with public policy formation. She is often cited in legal opinions for her work in the area of fraudulent conveyances. Ms. Mayerson served as examiner in Interco’s Chapter 11 bankruptcy matters about which she wrote a report on fraudulent conveyance law. She also did groundbreaking work in the field of customer claims in security firm insolvencies as part of a New York-based financial services company’s Chapter 11.

Given what is going on in the bankruptcy world right now, as it related to fraudulent conveyance, I think this is a fascinating interview - and one applicable to current on-the run situations.

You can find the interview at the conference landing page here: Distressed Debt Interviews Sandy Mayerson



Distressed Debt Investing Interviews Jonathan Flaxer and Douglas Furth

It gives me great pleasure to introduce Jonathan Flaxer and Douglas Furth, two partners in the bankruptcy, reorganization & creditors' rights practice at Golenbock Eiseman Assor Bell & Peskoe LLP, a full-service Manhattan law firm of approximately 50 attorneys which has served its clients’ complex litigation and corporate needs for over 25 years. Golenbock Eiseman Assor Bell & Peskoe LLP is a sponsor of the upcoming The Global Forum on Investing in Distressed Debt, a conference we are encouraging all of our readers to attend.

Mr. Flaxer and Furth have represented a number of clients in many high profiled bankruptcies including Calpine Corp (for ad hoc debtholder committee), Lyondell Chemical Company (representing the Indenture Trustee in fraudulent transfer litigation), and Charter Communications, Inc (representing the Indenture Trustee) among many others.


Given what has gone on in the Tribune and Tousa cases, do you expect to see more fraudulent transfer claims pursued going forward? How can lenders protect themselves better going forward?

Absolutely. Our experience representing the indenture trustee for the Millennium noteholders in the Lyondell case as well in other cases shows that the TOUSA decision and the examiner’s report in the Tribune case both offer significant encouragement for creditors to attack leverage buyouts. Lenders can protect themselves by keeping records that demonstrate careful due diligence and by obtaining contemporaneous fairness opinions. Of course, any transaction that does not include material equity capital risks later challenge.

Do you see the role of indenture trustee expanding over the next few years as fraudulent transfers possibly become more prevalent in bankruptcy proceedings?

Given the prevalence of activist bond holders in the market today, indenture trustees will inevitably be increasingly active players both as plaintiffs and defendants in fraudulent transfer litigation. In Lyondell, indenture trustees, played both roles.

The numbers of classes in bankruptcy proceedings seems to grow with each case. Do you think this continues or do you think the various layers of debt (1st lien, 2nd lien, 3rd liens etc) will continue to complicate and lengthen bankruptcy proceedings?

The increasing complexity of bankruptcy cases reflects the complexity of contemporary capital structures. In the early to mid-2000’s, complex financial products proliferated and complex bankruptcy cases became inevitable with the market correction. Investors can mine opportunities by carefully examining collateral packages with respect to tranches of secured debt and, with respect to unsecured debt, by reviewing guaranty obligations and subordination and other inter-creditor arrangements.

What is your outlook for the restructuring market in 2011 and 2012?

The “extend and pretend” approach that prevailed in 2009 and 2010 cannot continue forever. Eventually, the day of reckoning will come. This, coupled with the enormous overhang of debt coming due in the next two years, suggests an active restructuring market.

Given the changes brought on by the overhaul of the code in 2005, do you believe that more and more cases will go the pre-pack route? How will this affect creditors' and debtors' game plan as it relates to the restructuring process?

The trend toward pre-packaged and pre-negotiated filings will continue, although this is only partly attributable to the 2005 amendments. In this respect, senior secured lenders will continue to drive the process with a goal toward accomplishing as much of the restructuring as possible prior to the actual filing of the petition, frequently with the added goal of forcing an expeditious sale.

In your minds, what have been the one or two most important regulatory or legislative changes in the bankruptcy process over the last few years?

The liberal granting of administrative claims to certain pre-petition vendors coupled with the deadlines on debtor’s exclusivity and time to assume or reject retail leases, have made true reorganizations far more difficult.

We know that both of you have participated in some of the highest profile bankruptcy cases over the last few years - which of these did you find most interesting? Why?

It may be ancient history, but, the Marvel Entertainment case was a uniquely fascinating case. It involved an epic takeover battle between three legendary corporate titans that played out in the context of a chapter 11 case. Given the evolution of the Bankruptcy Code, it is unlikely that this kind of case will be seen in the near future. More recently the Extended Stay and Innkeepers cases have involved battles between groups of investors that are likely to be repeated in other cases in the near future.

What advice would you give to distressed debt investors in the market of 2010?

In a world where takeout financing is still hard to find, junior debt and equity classes are more often out of the money than in previous cycles and investments low on the balance sheet should be made with extreme caution.


Upcoming Distressed Debt Conference

Just wanted to remind readers that The Global Forum on Investing in Distressed Debt will be held this week in New York City. I have worked with the organizers of the conference and helped them put together a conference that will be value add to distressed debt analysts, traders, portfolio managers, and asset allocators. Over the next few days, we will have more interviews from speakers from the conference (really great material). Stay tuned.



One of the best pieces of investment advice I've ever read.

We have extensively covered the wisdom and writings of Oaktree's Howard Marks on the blog. In his most recent commentary, Marks puts into words quite possibly the greatest piece of investment advice I have ever read:

"At What Price?

That question - at what price? - isn't just the right question to ask about bonds versus stocks today. It's the right question regarding every investment at every point in time.

I try every chance I get to convince people that in investing, there's no such thing as a good idea...or a bad idea. Anything can be a good idea at one price and time, and a bad one at another."
He continues with quotes from letters, reiterating the same point:
"It has been demonstrated time and time again that no asset is so good that it can't become a bad investment if bought at too high a price. And there are few assets so bad that they can't be a good investment when bought cheap enough ... No asset class or investment has the birthright of a high return. It's only attractive if it's priced right."
Seth Klarman has made similar points:
"Risk is not inherent in an investment; it is always relative to price paid. Uncertainty is not the same as risk. Indeed, when great uncertainty - such as in the Fall of 2008 - drive security prices to especially low levels, they often become less risk investments."
And Warren Buffett with his famous:
"The future is never clear; you pay a very high price in the stock market for a cheery consensus. Uncertainty is the friend of the buyer of long-term values."
All three quotes lay out the same principle: Price is what matters.

When I hear friends talk about how terrible an investment idea is, I always pose the question: At what price would you buy this security?

In Howard Mark's aforementioned recent letter (found here) he discusses the current state of the credit markets. In a previous post on Distressed Debt Investing ("Credit Markets Quite Possibly Insane"), I talked about what was going on in the investment grade and high yield markets. Then things were getting nutty.

The last few days have convinced me credit investors have lost their minds (again).

On Bloomberg, their is a function - It is essentially what is going on in the new issue monitor in the credit space. The last three days have been the busiest I can remember in the primary space (across investment grade, high yield, and bank debt). Worse, all in yields are remarkably low and more and more dividend deals are getting announced. I do not think there is a second lien dividend deal out there (my indicator for "Sell Everything"), but I may have missed it given the enormity of the primary market.

Yes - I understand the argument - "Where else am I going to get yield?" But from the same people that asked the EXACT same question in February 2007. Dealers fuel the flame because when credit markets roar, bankers / traders / syndicate gets paid.

Maybe I have talked about this in past posts, but what really scares me is how fast the credit markets have changed from boom, bust, boom, bust this year. Yes, high yield is up 10%, but most of that is the curve tightening. The HY14 CDX Spread:

Look at that chart from January 1st, 2010. Spreads widen, spreads collapse, spreads wide, spreads collapse. Does this look like a healthy market to anyone? If investors started worrying more about price (spreads in credit land), versus chasing yield, this market would feel less insane. Alas, reach for yield continues, unabated - I hear the forward calendar continues to grow as CFO and treasurers RACE to beat the window of cheap debt issuance.

Who is going to be that last buyer who get's stuck holding the bag of the worst issuers? Tread carefully.



Content Contributors

Looking for a few good people...

Job Title: Writer / Content Contributor

Job Description: The Distressed Debt Investing Blog, the Merger Arbitrage Blog, the How to Get a Hedge Fund Job Blog, and the Value Investing Blog, seek three dedicated individuals to contribute content and write articles across the existing portfolio of sites as well as a number of new sites currently in development. We are looking for smart, hardworking individuals that want to be a part a growing financial news network on the web. Currently the network is receiving approximately 100,000 page views a month and has been featured in online editions of the Wall Street Journal, Business Week, the Financial Times, and a number of other major media publications. The positions will initially be unpaid, but the ideas is to grow the business and if successful, the candidate will receive equity and monetary compensation. Contributors will be able to use pen names or their real names as authors under the network of sites.

Job Requirements:
  • 2 years or more of front - off buy side experience
  • General knowledge of distressed debt investing and value investing concepts
  • Ability to write high value, well-written articles, 2-4 times a month (500-2000 words)
  • Strong communication skills
How to Apply:

Please send your resume, and a short writing sample (500-1000 words) on an investing topic of your choosing to hunter [at] distressed-debt-investing.com



Distressed Debt Investing interviews Mark Berman

We are very excited to bring you an interview with Mark Berman, founder and Managing Partner of MB Family Advisors, LLC and the MB Dislocation Opportunity Fund, L.P., a dislocation / distressed credit fund-of-funds. MB Family Advisors, LLC is a multi-family office investment firm founded in 2008 to manage investment portfolios for ultra-high net worth families across asset class, with a particular focus on alternative investments and investing in inefficient markets.

Mark will be speaking at the upcoming Global Forum on Investing in Distressed Debt, coming up this month in NYC. If you remember, this is an event I have helped to organize. I really hope all my readers will attend.

Enjoy the interview!

Mark - Could you give us a little bit of background on yourself and MB Family Advisors?

Sure. In a former life I started my career as an M&A attorney at Skadden, Arps but I’ve been a principal investor since 1994, mostly in firms where I was a Founder or Co-Founder and invested substantial personal capital alongside my investors. Initially I focused on small and mid-market buyout investing and had some great success as well as luck (for instance our marquee buyout transaction generated a return of almost 60x our equity investment). I started investing in hedge funds in 1997, both single manager and fund-of-funds. In 2001, seeing the inefficiencies in the private equity secondary market I co-founded a fund firm that purchased in the secondary market limited partnership interests in real estate private equity funds. The common theme to my investing career has been to focus on finding inefficient markets where a provider of scarce capital can generate outsized returns.

The search for inefficient markets required that I develop deep experience across multiple asset classes – private equity, hedge funds, credit markets, real estate etc. This broad experience led to the launch of MB Family Advisors, LLC in mid-2008 when I formalized a relationship with an anchor investor to manage his family’s investment portfolio across asset class. The anchor investor has a low 9-figure net worth. The intention has been that over time I would add additional family clients and on occasion offer specialized investment products that could opportunistically target particularly inefficient opportunities.

The first investment product came in January 2009 when I launched the MB Dislocation Opportunity Fund, LP, a dislocation/distressed credit fund-of-funds. The Fund is intended to provide investors with diverse exposure across a variety of different credit, distressed and other niche strategies including traditional long/short corporate distressed; asset based lending; structured credit; merger arbitrage; and mortgage debt markets (RMBS/CMBS & whole loans), among other strategies. The common denominator in all the Fund’s allocations is that we invest in strategies positioned to benefit from ways the capital markets have changed since the 2008 financial crisis.

We have to say, a January 2009 launch of a distressed credit fund-of-funds seems incredibly prescient. When you were looking out at the world at that time, why did you think that was the opportune time to invest?

Well, for starters I’d note that it’s more of a “dislocation” fund than pure distressed credit. As indicated, we’ll invest in any strategy we think has benefited from the 2008 financial crisis. Distressed debt is just one of the underlying strategies.

As for timing of the Fund’s launch, as I alluded to I think the best investment opportunities come from inefficient markets. As capital markets imploded in the Fall of 2008 credit markets in particular became so highly dislocated. Credit completely froze. While there was substantial continuing uncertainty regarding the severity of the recession it was already clear by year-end 2008 that the US and other developed country governments would not allow the complete collapse of the financial system. However, the complete lack of liquidity and fear associated with uncertainty created forced and/or highly motivated sellers resulting in substantially mis-priced securities and assets.

The mis-pricing existed across multiple markets including leveraged loans, ABS, DIP lending, ABL lending and others where all of a sudden you could target high, equity like returns or better investing at the most senior, least risky part of the capital structure. I wanted in on that action.

To get sufficient diversity of strategy and manager I decided to launch the fund-of-funds and take in outside investor capital. In hindsight our timing was good. It’s still early but we’ve enjoyed great success thus far and have generated positive returns in 18 of the 20 months since launch.

We see you have had tremendous success to date - What are your thoughts on the distressed market today? Do you worry that so much capital has entered the space over the past 12 months that returns going forward could be squeezed out?

The nature of the opportunity set has changed. Initially the opportunity existed to get 20%+ returns on high quality, performing assets that were not distressed but were trading at distressed prices. That trade is over.

For reasons I’ll describe, over the next 12-18 months I think there are other niche strategies more compelling than distressed corporate debt. However, there are attractive opportunities currently in some mid-market distressed names and beginning in late 2011 or early 2012 the overall distressed market will become extremely compelling again.

To me it’s clear that we’re in the midst of what will be a multi-year distressed cycle. The upcoming wall of debt maturities has over $1 Trillion in corporate debt coming due (and this excludes mortgage debt), much of which was issued in the go go years of 2005-07 and is stuck in unsustainable capital structures. Sure, “amend and extend” has kicked the can down the road but for many of these companies the day of reckoning will nevertheless come. At that point there will be a huge supply/demand imbalance in favor of distressed debt investors and 20%+ return potential will exist again.

Several high yield analysts have recently opined that all the debt extensions are solving the wall of debt maturity problem but I think they are misguided. High yield issuance is at record levels but something like 70% - 80% of the issuance has been for tenders to replace existing debt and extend out maturities. Yes, this has resulted in default rates coming way down for large cap companies that can access the high yield market. It’s true that this makes the distressed opportunity set much less attractive in the near term --say over the next 12-18 months -- but this is a temporary phenomenon. While you can solve a liquidity problem with more debt you generally can’t solve a balance sheet problem by issuing more debt unless growth is so robust that substantially higher cash flow can meaningfully shrink leverage and coverage ratios. (Unfortunately this is a lesson our government hasn’t yet learned but that’s a topic for another day.) The prospects for this type of hyper growth in cash flow are quite slim.

So, in the near term there will be fewer large on-the-run names in the distressed space and returns will be squeezed but with a little patience distressed debt will be quite compelling again. In any case, it’s important to appreciate that through Q2 of this year default rates for small and mid-cap companies were still in excess of 10%. These companies do not have access to the high yield market and have far fewer options to kick the can down the road. Therefore, in my view the most attractive distressed opportunities for the next year or two will be in the mid-market. This is an important consideration when assessing who to allocate distressed capital to.

Perhaps that’s a lot to digest but the bottom line is that I think (A) over the next 12-18 months there is more opportunity in other niche credit strategies like direct and asset based lending, (B) within distressed the best opportunities in the next 12-18 months are going to be in mid-market names and (C) as the day of reckoning on the wall of debt maturities gets closer, the overall distressed market will become extremely compelling again and offer 20%+ potential returns.

When you are looking to allocate capital to a manager, what do you look for? Do you tend to allocate across smaller funds or larger funds?

We take a portfolio approach so it’s very important the individual component allocations fit together well. To some extent this means limiting correlation among underlying managers, each of whom has to bring something different to make it into our portfolio. We intentionally have a mix of small and large funds. Generally speaking our bias is for funds that use no or limited leverage; that don’t have 2008 legacy problems either in their portfolio or business; and have a stable underlying capital base.

With regard to individual manager decisions, like most allocators it’s important for us to understand what the particular manager’s “edge” is and get comfortable with the manager’s superior talent, ability to source ideas, integrity, commitment to best practices in back office and reporting, and passion generally for what they do.

In addition, three super important hot buttons for us are (i) interest alignment, (ii) risk management and (iii) world class investment process. If we aren’t 100% comfortable with these issues then nothing else matters. I’d note that process generally is under-appreciated among many investors. Great results come out of great process, period. We’re much more focused on seeing a rigorous, disciplined and repeatable process than we are on recent historical performance.

Continuing on allocation, when looking at your group of portfolio managers in which you have invested, how do you determine which manager will get the next dollar of your investor's capital? Does it depend on the underlying portfolio manager's strategies?

Yes, strategy is critical. Going forward I believe the best investors will distinguish themselves by being in the right strategies, as the environment will be ripe to reward certain strategies and punish others. While there’s no substitute for talent and motivation, a B+ manager in a strategy with substantial wind at its back will substantially outperform an A+ manager in a strategy with headwinds. I am extremely attuned to this in portfolio construction and it does heavily influence the allocation of incremental investment dollars.

It also drives occasional redemption decisions. Early this year I redeemed from a credit fund that generated net returns of 45% in 2009. It was a difficult decision in that the manager was talented and had really delivered for us. However, it was a long-only fund focused on a particular segment of the credit markets. That segment had rallied so substantially to the point that the opportunity set going forward no longer presented a compelling risk-reward profile– so I redeemed.

The other consideration that’s also critical is liquidity. Different funds have different lock-up and notice requirements and, at least in managing the Dislocation Fund, we have to make sure we don’t risk an asset/liability mis-match. This is less important in managing the family office portfolios but even there you want to make sure you are being compensated if you’re giving up liquidity.

Among the strategies in which you allocate capital (traditional long/short corporate distressed; DIP lending; merger arbitrage; asset based lending; fixed income arbitrage; asset backed securities; structured finance; and mortgage debt markets), where do you see the most opportunity today? The least opportunity?

Our strategy allocations are driven by the broad thesis that the dislocation experienced since the 2008 financial crisis will persist for multiple years, creating both opportunities (and risks). There are three primary drivers of our opportunity set:
(1) The wall of debt maturities – as discussed earlier there is over $1 trillion of high yield debt and leveraged loans coming due (nearly $4 trillion if you include mortgage debt). Much of this will eventually need to be restructured which feeds classic distressed debt investment strategies;

(2) The availability of capital is highly bifurcated: for companies large enough to tap high yield, credit is widely available -- but for companies with less than $50M in EBITDA and those looking for asset based loans credit is still extremely scarce. This creates opportunity for those managing direct lending and ABL funds to invest at the most senior, least risky top of capital structure but still get high equity like returns; and

(3) Certain strategies are positioned to benefit from the deleveraging because far less capital is chasing the spreads. An example of this would be low risk merger arbitrage where spreads are materially higher than what they were a few years ago because prop desks have shrunken and hedge funds have far less leverage available.
Over the next 12-18 months I think the most attractive strategies fall out of the 2nd and 3rd drivers – i.e. those that can be a provider of scarce capital and/or those benefiting from deleveraging. In particular I think direct lending, asset based lending and merger arbitrage are quite attractive right now – offering the potential to generate equity like returns without equity risk. In addition to the attractive return profile, if executed properly they are relatively low risk and, importantly, come with little or no correlation to the public equity or fixed income markets.

We know many emerging distressed and credit hedge fund managers will be attending the IQPC Global Forum on Distressed Debt coming up in September. We know many smaller managers have difficulty attracting the attention of fund of funds. Could you shed some light on things emerging managers could improve to better attract outside investor capital?

Fundraising is difficult for emerging managers. In my view the best positioned emerging managers are those with a differentiated strategy. If it’s not differentiated the bar is so much higher as new funds do have higher business and operational risk.

That said, the data is clear that as AUM increases manager returns decrease. Emerging managers could do a better job of highlighting this data – it’s strange but I don’t see it that often in emerging manager pitch books. Many talk about their ability to focus on off the run names but don’t necessarily draw the cause and effect relationship supported by empirical data. Good allocators should already be aware of this but I think emerging managers would be well served by highlighting it more. Emerging managers that are committed to capping AUM at a certain size for a defined period of time may also send a message to investors that they are more focused on generating high returns than on high fees.

Of course, in today’s environment an emerging manager has to be committed to best practices with respect to back office, operational and reporting functions. Operational due diligence has taken on a heightened level of importance and it’s easy to say no to a good investor with only mediocre controls. This can be challenging for an emerging manager who has less resources than a larger fund but nevertheless the emerging manager needs to demonstrate this commitment if they want to attract institutional capital. Likewise, having a highly credible Administrator, Auditor and Prime Broker is also important.

Finally, for me interest alignment is critical with all managers but even more so for an emerging manager. That means it’s often a non-starter if a substantial majority of the manager’s net worth isn’t invested in their fund. You take a little bit of a leap with any emerging manager but can get a higher level of comfort if the manager has a larger investment than you do in his or her fund and is essentially managing their own capital and you’re along for the ride.

When we do invest with an emerging manager we’ll generally start small and build the relationship over time.

You have been incredibly successful in setting up a number of investment partnerships. What is next for you?

Never say never, and I suppose it’s possible the umbrella I operate under could change, but at this point it’s hard to see me doing anything else. This is an incredibly fascinating time to be an investor. The investment landscape has changed dramatically since the 2008 financial crisis. There are so many opportunities and so many landmines, and the intellectual exercise of navigating that balance is more challenging and rewarding than anything I’ve done professionally to-date. I love how I spend my days. The challenges and uncertainty also place a higher premium on talent, which I hope accrues to my benefit.



Advanced Distressed Debt Lesson - Equitable Subordination

One of the best things about the Distressed Debt Investors Club is the collective knowledge of a group of very strong analysts and portfolio managers that have trafficked in a number of very complicated bankruptcy proceedings. No two bankruptcy cases are exactly alike. For various reasons (judges, capital structure and guarantees, covenants, outside interest), the chips can fall in a number of different ways in the same bankruptcy proceeding. The bankruptcy code and each of its articles can be interpreted differently by numerous parties. It is what makes distressed debt investing so fascinating.

With that said, DDIC member Paul has penned a piece for us on equitable subordination. Given the complexities of capital structures that have evolved over the past cycle, it is a crucial concept for distressed investors to understand. Enjoy

Equitable Subordination

Analyses of distressed investments often range from the relatively straightforward to the mind numbingly complex. For investments in companies with a simple capital structure, investors will focus on factors such as cash flows, collateral value and terms of the governing credit document.

In larger, more complex companies, investors might have to analyze many additional issues involving restricted and non-subsidiaries, guarantees, security, baskets, carve outs, and covenants, just to name a few. When a company files for bankruptcy protection, additional considerations arise requiring an understanding of the bankruptcy code. One of these considerations involves equitable subordination.

Equitable subordination is a doctrine outlined in Article 510(c) of the Bankruptcy Code. The language from the Code states that equitable subordination allows a court to “subordinate for purposes of distribution” all or part of an allowed claim to another allowed claim when equitable principles require. Interestingly, the Bankruptcy Code does not provide guidance on when equitable subordination should apply. The Court, instead, typically relies on a standard created by the Court of Appeals for the Fifth Circuit involving three conditions:
  1. Inequitable conduct by the claimant
  2. Misconduct causing injury to creditors or the bankruptcy estate or conferring an unfair advantage to the claimant
  3. The finding of equitable subordination must be consistent with bankruptcy law
Distressed investors should bear in mind a few additional principles when evaluating potential equitable subordination issues. One is these issues involves the distinction between an insider and non-insider. An insider’s conduct is subject to a higher level of scrutiny than the conduct of a non-insider. Another issue involves the application of remedies in equitable subordination cases. In equitable subordination Orders, the Court will offset the harm suffered by creditors on account of inequitable, or unfair conduct. The Court, however, will not necessarily subordinate the full value of a claim as part of the remedy.

Equitable subordination is frequently alluded to in bankruptcy cases by investors who have witnessed a steep fall in the value of their securities. Courts, however, do not often find that questionable tactics prior to a bankruptcy filing meet the high standard of egregious misconduct required in equitable subordination cases. A recent exception to this rule of thumb is Yellowstone Mountain Club, a bankruptcy filing in the District of Montana. In this case, Debtor and the creditor committee claimed that a secured loan in the amount of $375 mm constituted a fraudulent transfer. Without getting bogged down in the legal details of the case, the Court ruled in favor of the Debtor and creditor committee, finding that the lender’s actions “were so far overreaching and self serving that they shocked the conscience of the Court.” As a remedy, the Court subordinated the lender’s secured claim to the claims of unsecured creditors in the case.

With a robust understanding of equitable subordination, distressed investors should tread carefully as they evaluate purchasing senior securities that may have unfairly disadvantaged junior securities in a capital structure.



Distressed Debt Investing Primer

Gramercy has put together an incredible overview of distressed debt investing. Gramercy is a dedicated emerging markets investment manager based in Greenwich, CT with US$2.5 billion of assets under management. The firm offers investors superior risk-adjusted returns through a comprehensive approach to emerging markets supported by a transparent and robust global platform. Gramercy offers both alternative and long-only strategies across all asset classes (external debt, local currency debt, corporate high yield debt, distressed debt, equity, macro, private equity, and special situation). Enjoy!



Exclusive Interview: Jon Moulton

It gives me great pleasure to bring to our readers an interview with private equity legend Jon Moulton. Between 1997 and September 2009 Jon Moulton was the Managing Partner and founder of Alchemy Partners. Previously at CVC, from 1985 to 1994 Jon was the Managing Partner and founder of Schroder Ventures, where he focused on LBOs and venture capital. Between 1994 and 1997, Jon was the Director in charge of LBOs at Apax Partners. He has been involved in numerous turnaround deals since 1980.

In late 2009, Moulton launched Better Capital, a fund focused on the acquisition and operational turnaround of underperforming businesses. Moulton and Better Capital have been in the news recently with their purchase of Reader's Digest UK.

Jon Moulton will be speaking at the upcoming European Investing in Distressed Debt Forum. For all those that are interested, you can listen to the podcast as well as read the transcript, here:

And to all my readers: If you have any feedback or additional questions for Moulton, please contact enquire@iqpc.co.uk or +44(0)20 7368 9517.

Enjoy the interview!

Big Challenges, Extraordinary Opportunities and the Coming Wave

Jon, thanks for joining us. Now, firstly, can you give a little background on yourself and the founding of Better Capital?

Yes, I’m quite an elderly, private equity man. I’ve been around for thereabouts 30
years and greatly enjoy it. My previous firm was a mid-market private equity firm that really
didn’t want to focus on turnaround, so I left them and set up Better Capital last autumn. We
did it in a rather unique way. We set it up on the public markets. We’re now on the main
market of the London stock market. We raised £210m with a view to invest solely in
turnarounds of UK and Irish companies, hoping to basically make some money out of the grief
driven by the recession.

Jon, out of all the organisations that you’ve been a part of,
which experience did you find the most rewarding? And also, which deals stand out in your
mind as just incredible successes?

This is a really difficult question, because I’ve been around for an awful lot of
different deals with different characteristics. In terms of making money, probably the best deal
I ever did was one at £243 million, which was a deal with AG Stanley, a retailer we bought out
of. But in terms of deep satisfaction, probably Parker Pen is a deal that really stands out in my

Parker Pen was a business in Janesville, Wisconsin, though it was known all
over the world. Most people thought it was a British company. It was run terribly, losing £20m
a year, or thereabouts. It had all kinds of liabilities, nonsense, massive overheads.

We did something amazing: we bought the company quite cheaply, closed the head office in
the United States and put one of the subsidiaries, which was the English subsidiary, in charge
of the world. It had a delightful chief executive, Jacques Margry. And over the course of the
next seven years, with management working with us in a productive way, that was really
rather nice to do.

We took that to making £40m-odd of profit, and a hugely successful deal
with seven years of 72% IRR. And it was, by the standards of the industry, a fantastic deal.
And lovely people to work with, delightful company. Everything went in the right direction. The
only sad bit was actually it was sold to Gillette and two years later it was back in loss, which
shows the impact of not having the right management. But it was just an incredible success,
delightful people. It made a lot of money and it funded several very successful divorces.

Can you talk about another of your deals, Better
Capital’s acquisition of UK Reader’s Digest - what was your rationale for this purchase?

Right, well, UK Reader’s Digest was a very unusual deal. Reader’s Digest is a US
corporation, a big one. It had got itself into some difficulty with rather an unpleasant balance
sheet - too much debt and massive pension liabilities in both the US and the UK. The UK
operation was making a modest loss on sales in the sort of £60m-something range, but it had
an enormous pension liability. I don’t think we ever knew what it was, but something well in
excess of £100m. The company thought it had negotiated a deal with the UK pensions
authorities, the Pension Protection Fund. It was really startled, having thought it had agreed it
and sorted out its problems in the UK, to have the pensions regulator overrule the Pension
Protection Fund - something which we don’t think has ever happened before or since.

As a result, it had to put the UK into bankruptcy and to administration, which it did. And it w
ouldn’t buy it back, the US parent, without actually significant risk of the pension fund being
reassessed under the rather severe UK pension rules. So, the deal was very odd, because, of
course, the parent was actually letting one of its biggest subsidiaries lose its brand name, so
a very unusual deal.

From where we sat, it was a company that was really rather heavy with costs in the UK. Its
offices were in Canary Wharf, which seemed unnecessarily luxurious. The combination of rent
and its pension liability meant that the company started off at about -£8m before it started to
work, in a year. So, we’ve taken out all that cost, made some management changes, started
putting in some new IT systems, and we’ve seen an enormous benefit. The company is
trading far, far better now and we’re pretty optimistic about the future.

The business is an unusual one. Most people think it’s just the magazine; the magazine is
actually only about 15% of their revenues. Realistically, they’re a very effective direct mailer
that sells lots of books, DVDs, CDs, and financial services. It’s going well. Our rationale for
the purchase was quite straightforward: we could buy it reasonably cheaply. By turning it into
substantial profit, we would hope to make a lot of money.

Now, moving on to the economic crisis, which is
obviously still a key topic, you were quite prescient in your predictions for the economic
malaise that we find ourselves in today. I understand that you’re also quite negative on the
economic prospects for the future in the UK and Europe. Now, how does that shape your view
of the future of turnaround and distressed investing?

This is the toughest question, I think, you could reasonably ask me. What is very
clear at the moment is that the only certainty is uncertainty. The European and UK economies
are full of issues - too much debt, too much sovereign debt, large deficits, the effects of
pulling back those deficits, pulling in public sector spending, weak demand. Today we’re
looking at stock markets falling all over Europe.

The future of the economy, though, looks to me to be fairly bleak. We’re in the middle of a
bombed bubble with very, very low interest rates. Those will reverse. When they reverse, we’ll
see the economy is going through a terrible shape, and the opportunities for distressed
investing will become very large.

At the moment, our basic approach is we’re only going to do really rather special and
attractive situations, and we’ve got to wait for the inevitable tidal wave of bad deals to come
hurtling towards us when interest rates rise and when the economic prospects become more
clearly adverse, both of which I sadly expect some time over the next year or two. I could
easily be wrong, but that’s certainly the basis we’re going for: no rush, wait for a wall to come.

How do you distinguish
between a business with a possibility of a turnaround versus a business in a permanent
secular decline? In either type of situation, how much does valuation come into play, versus
the possibility of getting your hands dirty in the business to improve operating results?

Right, okay. So, let’s start off. Businesses are in permanent secular demand. Say,
UK coal mining, you can make money out of it, because there’s cash flows. The companies
will generate more cash than they can handle. So, you have to buy them very cheaply. Those
kinds of opportunities still work. What you mustn’t do is buy a pretty-well dead business,
something which is just simply declining very rapidly, and no matter how quickly you cut the
costs and chopper the business, you never end up with much in the way of a positive cash
flow, and eventually the closure costs absorb everything you put in.

So, what we try and do - well, mostly actually - is buy companies which are not first division
companies, but they’re not the ones doomed to relegation, from the bottom division. The sort
of middle-of-the-road companies with modest growth possibilities, which, because of m
ismanagement, because of silly strategy, perhaps just because of ill luck with the litigation
or something, are in serious trouble. And these we can then buy at a reasonable price,
because nobody knows how to price loss-making companies, turn them into profits and make
some money out of it.

Now, the process of taking a company from loss to profit is sometimes really easy. Most of
the time it’s moderately difficult and it involves a number of steps. The more steps that you
need to take, the more difficult the steps are that you have to take, the riskier turnaround
becomes. So, I typically prefer shorter turnaround. It’s one which, I’m afraid, involves lots of
negative actions: closing things, stopping selling products. Just taking cost out, because that’s
predictable, controllable, whereas doing a turnaround which relies on increasing sales or
margins, that’s not so controllable; that’s much harder to predict.

The more you have to do, the cheaper the deal has to become, because obviously time is
money, and the more really difficult cases we take on, the less we can do. We’ve got to
the pile of money we have and the people we have to do it. So yes, it’s a trade-off,
sometimes a very difficult trade-off to estimate, because one of the other things about
turnaround companies is that typically they come with mediocre or even bad information, poor
financial controls, poor understanding and poor basis for us to understand it. You can make a
lot of money in all kinds of deals if you just keep your eyes open.

What do you look for in a management team? How do you find the
particular CEO that can turn a certain business around?

Well, the whole thing at the moment is that this is probably the easiest part of our
business. We know a very large number of turnaround chief executives, many of whom have
done somewhere between one and a half a dozen turnarounds before. And there aren’t as
many deals around as there are CEOs, so finding one is quite easy. What do you look for in a
turnaround management team? Well, you look for somewhat different characteristics than you
would in a stable business. First of all, you need a highly decisive management team. Better t
hat they take 100 decisions and get 80 right, than they take 20 decisions and get 20 right.

The company needs to turnaround quickly, stop losing, stop haemorrhaging. So, somebody
with a bias towards action; somebody prepared to tackle radical things; somebody prepared
to basically absorb the shock of the unexpected, because turnarounds are littered with those.
These characteristics are fine for taking a company from loss to profit; they’re typically not the
characteristics you want in somebody to run a stable business. So, turnaround managers,
quite often a couple of years out, you don’t need them and don’t want them. You want
somebody more stable, and the good turnaround managers know that too.

Which investors do you admire? Which investors have shaped
the way that you approach deals, Jon?

In the UK, I’m afraid, the field of potential investors in turnaround is really very
small. What have we got? We’ve got Endless, Rutland - those are the two largest names in
the marketplace besides us. It’s a very small field. In terms of which investors I admire,
people like Wilbur Ross from the US are far, they’ve done far more than anybody in the UK
has done in turnaround. You definitely have to give them their degree of admiration for doing
it. They’ve tackled some very, very difficult companies, and made an enormous amount of
money out of it. You see the same with people like the Gores group in the United States. The
scale of the turnaround market in the US is so much bigger than it is here. The heroes, I’m
afraid, are still at the other side of the Atlantic. If interest rates rise, if the banks discharge
their loads, then perhaps we’ll see some real heroes appear here.

Now, talking of the US, a significant amount of capital has obviously been raised
by private equity and distressed debt hedge funds to effectively pick up assets on the cheap. W
ould you say that this phenomenon is occurring in the UK and Europe in general, and
do you approach deals more cautiously in these types of environments?

Right. Several questions, really, underlying that. First of all, in terms of people
raising money for distressed debt investing, hedge funds, some of the giant international
players in distressed debt, like Oaktree, are here in very substantial volume. There’s no
shortage of buyers for distressed debt. And, as we speak, actually the pricing of distressed
debt looks pretty unattractive. There’s not much reward for quite a bit of risk. There’s no
shortage of money in the distressed debt area.

Private equity funds playing in turnaround on distressed in Europe in the UK, they’re much
thinner than the United States. There are less of us. And at the moment there needs to be
less of us, because the banks aren’t releasing assets in volume and the very low interest
rates mean that lots of really quite financially stretched, poorly run businesses can chug along
a little longer before the reality eventually bites on them.

So, does it mean that I approach deals more cautiously? No, not at all. They really don’t bear
on me. The private equity world is lowly competitive at the moment in turnaround. We’re really
not a distressed debt fund; we don’t just buy debt because we think it should be priced at 80
and it’s trading at 60. That’s a perfectly good way to make a living, but it’s not what we do. We
buy control of companies that need an operating turnaround, and there isn’t an excess of
competition at the moment; not like a mid-market private equity firm, where at the moment
there are 85 or so competitors in the London market alone.

Finally, we’re know you are speaking at the
European Investing in Distressed Debt Forum. One of the topics that you’ll be covering is ‘big
challenges, extraordinary opportunities, and the coming wave’. What key talking points do you
expect to come from this discussion panel?

Well, I’ll probably lead it off by talking about something which is really very
startling. We’ve just been through the biggest recession since World War II. Liquidations in
the UK are at a 30-year low, which is an incredible coincidence. You have to analyse why,
and it’s low interest rates, government support, through not collecting overdue taxes, and
banks because they’re either unwilling to recognise losses or prepared to really postpone
them into the future. All of those things mean that at the moment you can actually make a
rather unpopular argument that there’s an unhealthily low level of corporate failure, and that
the problems are being stacked up both in the economy and in the banks. That eventually will
break, and when it breaks it will be rather dam-like. The volume of deals to come forward will
be very large indeed; whether that comes in six weeks, six months, or a couple of years, I
don’t know, and that’ll probably be the subject of some animated debate. But those are
among the big issues.

Thanks very much for your time today, Jon. It’s been great to hear
your points and hear about how you operate at Better Capital!



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.