Distressed Debt Themes for 2012

I think the one word to describe this year's distressed debt market was "unexpected."  Whether it be the tragedies in Japan, Congress pushing us to a near technical default, the subsequent U.S. government downgrade, heightened and unforeseen issues with Europe, and a number of surprising bankruptcy filings (MF, AMR, etc), this has been a tough year to price risk for a distressed debt investor.  According to HSBC's most recent "Hedge Fund Weekly", hedge funds classified as "Distressed Security, Global", excluding Paulson & Co affiliated funds, have seen year-to-date returns ranging from -9.5% to 7.4% with a number of funds hugging right around zero.

While I will save my post discussing the expectations for high yield returns for 2012 (I know, a fool's errand) for next week, I would like to talk about some issues and themes that distressed debt investors may possibly encounter through 2012.  But first, let us look at my favorite chart:  The number of distressed debt issuers traded over the course of the year:

(Note: I've cut the graph off as of two days ago to account for the dearth of trading around the holidays)

As this chart shows, the distressed opportunity set has increased precipitously over the past 12 months.  Many of the new opportunities comes from junior capital (TRUPS, preferred, unsecured bonds, etc) of European banks.  In addition, as the definition of distressed according to Bloomberg is a spread of over 1000 basis points along with a much tighter treasury curve, the bar is set a tad lower this year.  With that said, I think any investor you speak to participating in the distressed debt market would tell you there is a lot more to do at this time time year than last year.

In terms of themes, I might as well get the elephant in the room out as quickly as possible:  Europe.  I have read every major investment bank's credit outlook for 2012 and everyone's projections for next year's returns are based on possibly scenarios in Europe.  If you were to compare the two issues that rocked the equity markets over the past 12 years (the "Tech Bubble" and the "Mortgage Crisis"), issues in Europe are so heavily portended that I'm starting to wonder how much is already discounted in.  I mean, were people talking about the Tech Bubble in 1999, like they are talking about Europe today?  Were (informed) people talking about the mortgage crisis in 2007, like they are talking about Europe today?

I have no idea what is going to happen in Europe. I am not a macro analyst and find myself much more comfortable (and at an information advantage) discussing various bottoms-up situations than trying to guess which European Summit, if any will fix the problem.  With that said, you can't ignore the situation because that is what is driving monthly returns (in fact, an interesting data point: many funds have put on hold hiring fundamental analysts for the mere fact that the added value is muted by macroeconomic / Europe factors).

One way that I like to think about situations is determining, where on a bell curve, the situation is priced.  Here is the standard bell curve we all learn taking the CFA exam or intro stat:

Where the entire European debacle began to unfold, the +1/-1 standard deviation events were not priced in.  I'd say, with everyone focused on Europe, the +2/-2 standard deviation events are probably pretty closed to being priced in and the thing you have to worry about as a portfolio manager are the very far tails, for instance, and Italian default.  12 months ago if you told people you were pretty confident that Greece was going to default, they'd say, "You know, its a possibility...but probably not."  CDS on Greece has gone from 1000 basis points to 10,000 basis points (I don't have the points up front data in front of me) just this year.  Everyone expects some sort of Greek default.

The question I then fall back on is this:  Will Europe suffer a mild recession or a very bad recession?  The problem with a very bad recession is the domino effects it has on the rest of the world.  Here is the scenario:

  1. Europe falls into a bad recession
  2. Europeans purchase less due to austerity measures (wage cuts, higher taxes, etc)
  3. China's economy, which benefits from Europeans purchasing their goods, slows down on lower exports
  4. Australia, Singapore, Korea - all major exporters to China, slow down because China has slowed down because Europe has slowed down
  5. Global commodity prices (and definitely Australian real estate) drop because China has slowed down
  6. Major commodity producers, other than China, including Brazil, Canada, and Russia slow down because exports are lower due to lower prices and lower demand from everyone above
  7. Pain
Do I think this will all happen?  I am probably more likely to tell you these events will unfold than the average person on Wall Street.  But that's why there is something called "tail hedging" (Up until June, Australia CDS was one of the cheapest tail hedges out there).   

With that said, lets turn our focus to more structural / technical / non-European issues distressed debt investors will deal with in the coming year:

Lack of Liquidity and the Implications for Portfolio Management

I have discussed previously about the current abysmally low dealer inventories of corporate bonds. This has been driven by adoption of (absurd) regulation and de-risking of dealer desks across the Street.  What concerns me is that as absolute yields in the high yield / leveraged loan marketplace has decreased while at the same time the relative yield offered by high yield / lev loans relative to other fixed income has increased, the amount of retail money that has flown into the space has increased precipitously.  More retail money means more needs for cash and daily liquidity.  This has a dramatic effect on how a PM will manage a book.

First, it means that the relative spread between illiquid and liquid issuers should increase.  As more daily liquidity is needed, the demand for larger / on-the run bonds increases relative to smaller issues.  This should cause stressed high yield, which is generally illiquid, to gap out even further when bad news hits the tape.  The additional volatility will cause distressed debt investors to demand a higher discount rate when purchasing small issues meaning lower prices.  If you extend this to the point of financial distress, companies should be pushed into bankruptcy more frequently as the need for higher IRRs for distressed suppliers of capital becomes impossible to bear for the marginal issuer.

Secondly, inflows and outflows are inherently volatile and streaky (returns -> more inflows -> higher returns -> further inflows).  And because cash management will be focused on the most liquid issuers, these issuers will experience a whole different sort of volatility.  Now, you may not think this is important until you look at the top holdings of many of the well-known high yield mutual funds: TXU, Sprint, Clear Channel, First Data, HCA, Harrah's / Caesars, etc.  Most of the issuers have rich capital structures with every sort of layer imaginable.  And as spreads widen due to the aforementioned volatility in the senior parts of these capital structures, the junior parts of the capital structure will widen out precipitously.  This is a sort of minefield for investors that will have to be reckoned with next year.  

Third, and sort of a byproduct of our second effect, is that cash balances, should in theory be hire.  This concerns me because when cash balances are high, the propensity for rallies to extend past economical sense increases.  If I am a mutual fund manager sitting of 5% cash position and the asset class grinds in every single week, at some point, I am going to lower my cash balance and spread more gasoline on the fire.

Fourth, and possibly a stretch, private equity will target larger companies next year and the years beyond.  To me, it's a lot easier to finance a $5 billion entity that is levered 4.0x versus a $500M entity levered 3.0x, all else being equal.  And with the amount of capital sitting on the sidelines of private equity, just waiting to be deployed, I think you'll see some big game being taken down next year.

Lower Recovery Rates

Many high yield strategists use a fairly simple formula to calculate projected high yield spreads and as a result, total return over a projected period:  

[100% less Estimated Recovery Rates] * Default Rate Forecast + Excess Spread = Spread Estimates

The problem with this equation is pretty simple:  Excess Spread changes with market volatility.  In a very volatile markets, excess spread, or the spread an investor requires to be paid above what he expects to lose in a default scenario, increases dramatically.  Hence, you have a circular equation.

More important to our discussion is my estimation that we will see lower recovery rates in the future, more specifically in the lower parts of the capital structure.  Whether it be bank debt or secured bonds, more senior leverage is being put on capital structures, leaving junior note holders in a more levered position.  Furthermore, the extremely weak covenant packages put into credit agreements and indentures between 4Q 2009 and 2Q 2011 means while the chance of an actual default is less (less likely to trip covenants if they don't exist), the companies that do default will already have been burned to the ground.  

 Higher Default Rates but still Relatively Benign

Despite my concerns in Europe, I cannot dismiss the data that suggests high yield issuers in the United States have the strongest balance sheets, collectively than in anytime in the modern history of high yield.  And the maturity wall is really just a hill now:

We always see a few surprises each year.  This year, other than MF, we saw AMR file.  Of every analyst covering AMR on the equity and debt side, very few, if any, thought AMR would file in 2011.  Dynegy is a similar story given the pricing of the various HY indices.  Jump risk is something we all have to contend with in the distressed market and 2012 will be no different.  I would expect default rates to increase into the latter half of the year as CFOs and investors alike begin to look out 12-18 months when lots of bonds and bank debt are maturing while at the same time the amount of firepower of CLO purchasing power dwindles due to the closing of their reinvestment windows.

With lower recovery rates in the junior tranches, I'd expect distressed investors to make an even more pronounced move into 1st lien paper (akin to Oaktree's strategy).  Something like a Travelport 1st lien comes to mind.  

More Cash to Invest due to Distributions from Liquidations

Lehman.  Nortel.  Washington Mutual.  To the innocent by-standers eye, simply three companies that filed for bankruptcy.  To me, and many other distressed investors:  An oasis or bastion of safety.  Nortel has been one of the best performing distressed bonds all year.  WAMU, whichever flavor you choose, has been a solid performer the past few weeks.  And Lehman:  Lehman has let you allocate billions of dollars of capital in just a few trades allowing you to show your investors your are more allocated than you really are while at the same time grinding out returns.  I have a recovery price in the low 30s for LBHI.  Every day I suspect my bonds will grind their way there with little no volatility.

Unfortunately, this party is about to end.  Lehman should start paying out distributions soon, and its just a matter of time for WAMU and Nortel once all the arbitration gets settled and the plan is confirmed, respectively.  Distressed debt investors will find a bunch of cash from these distributions in their fund, looking for similar places to put the capital.  But really, there aren't a lot of situations like that right now.  MF could turn into such a situation, but we are far from that will over a billion dollars still missing.  Maybe this capital will move into something like merger arbitrage (remember our point above about private equity taking down larger targets).  I'd expect to see DIPs massively oversubscribed next year on the bankruptcies we see.  Maybe the capital will move into Europe as European banks trickle out assets despite new collateral rules letting them pledge anything under the sun.  Or maybe investors start taking bold position in deeply distressed situations looking for control while at the same time exposing their investors to more volatility.  My dark horse candidate:  A healthy push into sub-prime and other non-agency RMBS and CMBS. 

Activism (in and out of the bankruptcy court) to Increase

In my opinion, and as mentioned above, the financing market for good and sizable companies is healthy right now.  A healthy financing market fuels activists as they can push for a hostile offer more reasonably with committed financing.  And even if they really do not want to take the company private, the white knight will also find himself with many options to finance a purchase.  For investors in credit, I think the combination of a healthy financing market AND lower recoveries for junior tranches will push distressed investors to write large equity / rights offering checks to give them a chance to recover their investment less they hand the keys over to senior creditors.  We saw this with Great Atlantic.  

As capital structures get more fragmented / layered, and intercreditor agreements become more friendly to revolving lenders, junior creditors are in a unique spot to "create their own recovery" as it were.  One of the most successful endeavors of this sort was Six Flags, where originally bank debt was going to retain the equity.  Then it was the opco noteholders.  Then finally, after a large equity check, the holdco noteholders took over the company and we know what happened there:

And to answer your next question:  Doesn't this contradict with what you said about lower recovery rates?  No.  In fact, it worries me because smaller investors that cannot participate in rights offerings will see a much lower ULTIMATE recovery than their peers that have the chance to participate in an equity check.

This strategy is bound to be profitable, assuming a low enough purchase price, as EVENTUALLY, Europe will correct itself, and valuations across industries will increase  If you can purchase a company in distressed with cheap financing, delever the structure, and fix operations, I think you'll have yourself a home run. 


Everyone is calling for 2012 to be a volatile year.  I hope just the opposite: I hope everything goes lower and assets across the board get cheaper.  But with everyone painting a doomsday scenario, I'm not quite sure that will happen.  The market is NOT ready for a sustained bullish rally - too many investors are flat or are running with a low gross exposure.  The only thing that I've known to be true in macro prognosticating: The market will move in a way that hurts the most people at anyone time.  If everyone is long, it will go lower.  The pain trade today, surprisingly, is up.  It's going to be a hell of an interesting year.  Good luck.



Distressed Debt Weekly Links of Interest AND a few Updates to Recent Posts

This week I am going to try something new.  Because there was a litany of news from the docket of a number of the bankruptcies we have followed in the past, I thought it would be beneficial to the reader to get a summary on some of the proceedings.  First the updates, then the weekly links of interest:

Great Atlantic settles with Secured Note Holders: We have discussed the Great Atlantic & Pacific Company's bankruptcy in a number of posts.  Most recently we discussed the calculation of the claim value of the company's Second Lien Senior Secured Note Holders.  This week it was announced that the company has entered into a plan support agreement (PSA) settling the amount of the claim at $304M with per-diem adjustments of $108,000 if the company exits bankruptcy before or after the assumed March 1, 2012 date.  This works out to an approximately 119 price on the bond.  I have to assume the company, under the direction of the junior note holders who are funding the rights offering, wanted to avoid any sort of delay in the bankruptcy confirmation (which may have been held up if the Second Liens litigated for the make whole).

Dynegy and PSEG reach agreement on Roseton / Danskhammer leases:  Importantly, this does not settle the amount of the lease rejection claim in the bankruptcy court.  As first discussed in this post: Dynegy's Bankruptcy, Dynegy filed for bankruptcy in November to restructure its capital structure and reject the leases on the Roseton and Danskhammer power plants.  What this agreement does though is leaves the pass-through notes as the only really opponent to the rejection of these leases and the associated damage claims.  Under the agreement, PSEG would receive an allowable claim of $110M against Dynegy and would receive $7.5M in cash from Dynegy, among other things.  From a valuation perspective, this means that the unsecured bond holders will receive slightly less as claims have increased marginally at the debtor.

And now the "Weekly Links of Interest"

An amazing insider look at manager's capital allocation decisions [hat tip Joe Koster's Value Investing World]

Another one from Joe:  A series of lectures from Bruce Greenwald's Value Investing classes at Columbia Business School [Value Investing World]

Zero Hedge's Chronicle of the Last Days at MF Global [Zero Hedge]

Latham Watkins with a detailed look on the amended Bankruptcy Rule 2019 [Latham Watkins]

Sardar Biglari's 2011 Annual Letter to Shareholders [Biglari Holdings]

Kyle Bass at AmeriCatalyst 2011 (amazing video!)



New Items in the Right Sidebar of Distressed Debt Investing

First off, I'd like to thank everyone that has volunteered to write for the site. I would say we have 3 of our 5 spots definitively filled, and you soon will see their names / affiliations / links to all the articles they write in the right sidebar in the coming months. If you are interested, please contact me via email.

Importantly though, I received about 20-25 emails for people wanting to write about a specific situation here or there, but not with a firm commitment. I always find myself (and I am sure many others do as well) with too little time to cover and analyze every situation. With that said, I thought I would try an experiment: On the right sidebar, you will see a section entitled "Want to help out?" Whenever a situation comes up that either (1) I haven't followed and someone who knows the situation well would be better suited to write it up or (2) Many readers request a post on a particular topic of discussion and I don't have time, I will update that box.

So currently it read: "I am looking for someone to analyze PMI and determine the value of its unsecured bonds" PMI filed for bankruptcy a few weeks ago and bonds have drifted lower (even more so recently with the CDS auction). If you have looked at the situation, and would like to help out, all I ask is you email a few paragraphs to one/two pages explaining the situation and stamping a reasonable set of parameters / assumptions to get to a valuation.

When I get a sufficient response, I will use the work in question and develop a more comprehensive post incorporating elements from the author. And to get in front of a few questions I will get asked: Anything you send to me is 100% private / anonymous. If you would like me to post your name / affiliation, I will do that, but privacy is of the utmost importance around these parts.

Once the new post is up, I will change the "Want to Help Out Request" to a new situation and hopefully get more responses. I think this system will benefit all because (in theory) I will be able to cover more situations, more efficiently, and you as the reader, will be able to see more analysis of the many bankruptcies that seem to crop up more and more each day. Contributors will be granted a 6 months membership to the DDIC, access to me for resume/case study services/job search help for free, and will be invited to be a trial / beta user for our new project to be announced in 2012.

Here's to hoping we have a few PMI analysts out there! If you have any questions / thoughts, always feel free to email me at hunter [at] distressed-debt-investing [dot] com



Washington Mutual and DIMEQ

One security that has fascinated me and many investors for a number of months is the Dime litigation tracking warrants (DIMEQ). Without getting into the nitty gritty details and history of litigation participation certificates (If you are interested, read this document: POST-TRIAL MEMORANDUM OF LAW OF DIMEQ), the issue regarding DIMEQ in the Washington Mutual bankruptcy is whether the security should be considered equity of pre-bankrupt Washington Mutual, which for all intents and purposes is worth very very little, or something else entirely.

On one side of the table you had desk analysts arguing that DIMEQ will be considered equity and hence WAMU Holdco bonds would get a pop because they will receive a larger slice of pie (recovery). On the other side, you have one of the most focused legion of vested independent investors I have seen, discussing a very complicated issue, at the DIMEQ InvestorHub Message Board.

Earlier this week, Washington Mutual filed its 7th bankruptcy plan and disclosure statement. For those interested, here are the documents: WAMU's 7th Amended Plan and Disclosure Statement.

One investor that has been following the situation religiously is DDIC member Madclown, who writes a wonderful little blog entitled The Diligent Investor, which focuses on bankruptcy situations that most retail investors can participate. He contacted me last night with a post on the WAMU Plan and Disclosure Statement, which I've copied and pasted below. Enjoy!

Assessing the Impact of WAMU’s Reorganization Plan on the Dime Litigation Tracking Warrants (DIMEQ)

On December 12, 2011 Washington Mutual released the Seventh version of its Plan and Disclosure Statement. Woven within the Plan is a settlement agreement that provides for a recovery to equity holders in the form of Newco stock while dismissing charges levied by the Equity Committee against certain creditors for Insider Trading; charges that the Court found to be “colorable claims”. The recovery to equity represents a significant departure from the 6th Amended version of the Plan which did not provide for any recovery to equity.

These changes effectively put a floor of value underneath the litigation tracking warrants ("LTW") in a worst-case scenario if the Court rules against the LTW Holders in the Adversary Proceeding because the Plan provides that, in the event that the Court finds that the LTWs represent equity interests as opposed to either Class 12 General Unsecured claims or equitable lien claims, the LTWs will share a 30% stake in the Reorganized Company pari passu with common equity. In order to find that floor of value one must first determine what the reorganized Company is worth and then determine the proper conversion rate of LTWs into common equity to find the relative ownership percentage of this 30% stake for DIMEQ and WAMUQ. For simplicity’s sake we will assume that the Newco is worth $210 million which is the value assigned by the Court for the purposes of deciding “who gets what” under the Plan. As to the issue of the conversion rate, the Plan provides that the relative value of DIMEQ will be determined to be the lesser of:
  • The amount estimated by the Bankruptcy Court as the maximum amount in which the Disputed Claims relating to the Dime Warrants may ultimately become Allowed Claims times the per share price of Common Equity Interests on a date established by the Bankruptcy Court bears to the market capitalization of all other Common Equity Interests (as determined by the Bankruptcy Court using such same per share price)
  • The liquidated amount determined, pursuant to an order of the Bankruptcy Court, as the amount in which the Disputed Claims relating to the Dime Warrants are Allowed Claims times the per share price of Common Equity Interests on a date established by the Bankruptcy Court bears to the market capitalization of all other Common Equity Interests (as determined by the Bankruptcy Court using such same per share price)
  • The amount established by the United States Court of Federal Claims in the Anchor Litigation, pursuant to a Final Order, as applied in connection with the Dime Warrant Litigation, times the per share price of Common Equity Interests on a date established by the Bankruptcy Court bears to the market capitalization of all other Common Equity Interests (as determined by the Bankruptcy Court using such same per share price)
  • Such other amount as may be agreed upon by the plaintiffs in the Dime Warrant Litigation and the Liquidating Trustee; provided, however, the recovery in connection with the Dime Warrant Litigation will not exceed the lesser of (1), (2), (3) and (4) above,
I contend that this conversion rate is patently improper because it basically converts one share of DIMEQ into one share of WAMUQ and then adds the relative market caps and divides the total back into the improperly constructed DIMEQ market cap. The Debtor’s conversion method inexplicably ignores the conversion rate provided for by the LTW Agreement and further memorialized in an 8-k filed on March 13, 2003. Under the proper conversion method the “Adjusted Litigation Recovery” is divided by the “Merger Adjusted Stock Price” and then further divided by the number of outstanding LTWs. See calculation below.

So what exactly am I saying is the proper conversion rate? To simplify, we basically have to add the relative value of the LTW claims to the market capitalization of WAMUQ (1.7 Billion shares times the market share price of WAMUQ at a date to be determined) and then divide that total back into the value of the LTW claims. Now there are 4 possible amounts to assign as the value of the LTW claims which includes the lesser of the Estimated Claims ($337 million), the final allowed claims determined by the Bankruptcy Court (TBD), the final allowed claims determined by the U.S. Court of Federal Claims (TBD) and any stipulated amount agreed upon by and between the Liquidating Trustee and the LTW Plaintiffs (TBD or N/A).

We know what the highest possible claim amount is for DIMEQ and that would be the estimated Disputed Claims Reserve amount of $337 million. If one assumes that the LTW Plaintiffs don’t agree to less in a stipulated settlement, then the lowest amount that could be assigned to the LTWs would appear to be in the $228 million context. One can arrive at that value by taking the $356 million “pre-grossup” award from the Federal Claims Court (assuming the additional $63 million award is not awarded) plus the $104 million grossup less estimated litigation and issuance expenses of $22 million and that total then multiplied by a 38.757% tax rate (JPM’s estimate) and then reduced by 15% for the 85/15 split with WMI.

This whole exercise is, of course, a moot point if the Court finds that the LTWs constitute Unsubordinated General Unsecured Claims. The Court may also find that the LTW Claims are secured claims in the event that the Plaintiffs prevail on their Equitable Lien via Constructive Trust theory. In any event, whether the LTWs represent Unsubordinated Claims or Equity Interests and whether the Debtors prevail in their use of an improper conversion rate, it is now clear that the LTWs have value. What is also implicit in all of this is that barring any stipulated settlement between the Debtors and the LTW Plaintiffs, the Court will still have to conduct a final claims estimation hearing for the LTWs.

One final point I will make here is that the Plan currently provides that if the LTWs are deemed to be Equity Interests then they are an impaired Class and are not entitled to vote. Under this Plan construct it would apparently foreclose an LTW Holder from appealing the Judge’s decision to the District Court. Since there are many issues involved in the LTW Adversary Proceeding that are appealable and in the event that the Court finds the LTWs to represent Equity Interests, the LTW Holders should be given an election to either accept the treatment provided for under the Plan and to grant the applicable releases or in the alternative should be given an election to reject the treatment under the Plan, grant no releases, and take up any adverse ruling on appeal.

Conclusion - And most importantly, bottom-lining it:

The max upside in this case for DIMEQ that would result from being classified as a Class 12 GUC claimant or an equitable lienholder is about $3.00 per LTW (versus today ~ 65 cents) before post-petition interest if the full $337 million reserve goes to the LTW Holders. If the federal judgment rate is applied to that award for 3.5 years it moves the recovery up to about $3.20. On the downside, if DIMEQ is deemed to be Equity and if the Debtor prevails in applying the improper conversion rate then the worst scenario based on Plan value would put the DIMEQ security between $0.07 and $0.10.



Distressed Debt News: Lee Bankruptcy Filing

Today, Lee Enterprises ("Lee" or "the Company") filed for Chapter 11 bankruptcy protection in Delaware. This was anticipated per an 8K filed last week by the Company that stated:

"Pursuant to the Lee Support Agreement and the Pulitzer Support Agreement, the News Release announced, among other things, that Lee and its majority-owned subsidiaries expect to file voluntary petitions for relief under Chapter 11 of Title 11 of the United States Bankruptcy Code on or about December 12, 2011. Lee’s interests in Tucson, AZ, and Madison, WI, are not included in the filing. The Chapter 11 filings will be made pursuant to a “prepackaged” restructuring plan with the support of Lee’s Supporting Lenders (who represent approximately 94% of the total outstanding loans) and the Supporting Noteholders (who have provided unanimous support).
For those interested, the Lee Bankruptcy docket can be found here: Lee Bankruptcy Docket and the main claims agent page can be found here: Lee Claims Agent Page. As usual, we've added the docket to our bankruptcy docket page which can be found here: Distressed Debt Investing collection of bankruptcy dockets.

For reference, as of this evening, Lee Enterprises's term loan as well as its revolver, traded in the 66-68 context. As of the petition date, there was $548M of Term Loan outstanding and and $308M of outstanding borrowings under its revolver.

Negotiations for this pre-pack have been going on for sometime. For those in the market, you may remember Lee attempting to market a refinancing package earlier this year in the April/May time period for its debt maturing in 2012. When that didn't work out, negotiations began and eventually entered into a support agreement in August of this year with votes on the pre-pack being solicited in November.

The essence of the plans is as follows:
  • $40M DIP via Deutsche Bank will roll into new revolving credit facility
  • Existing holders of pre-petition credit facility will receive their $689.5M of a new first lien term loan facility and $175M of a new second lien facility (that has been backstopped by Goldman Sachs, Mutual Quest [Franklin Templeton], Monarch, Mudrick, and Blackwell Partners. The first lien facility is set to mature in December 2015, with the second lien maturing in April 2017. The pricing is L+625, with a 1.5% floor and 15% respectively (with a 5 point OID on the second lien)
  • Second lien lenders will also receive 15% of the outstanding stock on a PF basis
  • The "Pulitzer" noteholders will increase their coupon to 10.55% (that increase with time) and extend the maturity to 2015 and will see some debt paydown
  • Existing shareholders will retain their interests (holding 85% of the company before management incentive plans).
I will not that the 8K had slightly different figures for equity retention versus the disclosure statement (87% vs 85%).

Financial Projections from the Disclosure Statement (Exhibit F), are as follows:

Income Statement

Balance Sheet

Cash Flows

LTM EBITDA at Lee is around $170M. This versus the anticipated $990M of debt leads to leverage of 5.8x. This seems awfully high when you consider McClatchy trades at 5.5x today, but this seems to be already reflected in the market given the current trading price of Lee's credit facilities. I.E. With ~$860M of pre-petition credit facilities trading at 67, the market is implying a value of about $575M for the entity. This implies the new first and second lien paper will trade at a steep discount when they begin to trade. With that said, the company is projected to generate free cash flow of about $55M each year in the projection periods which will be used to de-lever the balance sheet.

First day hearings are scheduled for noon tomorrow in Wilmington with standard first day motions for a company putting forward a pre-pack. Lee is expected to exit bankruptcy within 60 days. We will keep readers updated if trading levels get to a price that interests us.



Quick Administrative Post

Three quick items of business:

1) If you have not, please head on over to our recent poll on what you would like to see on Distressed Debt Investing and let me know your thoughts. Remember, for those filling in a suggestion that I may have missed, I will choose the best suggestion and take that person + a guest out for dinner in New York City in 2012. Just remember to include your email address in the answer box (don't worry - only I will be able to see your suggestion + email addy).

2) Next year, I plan on adding four or five writers to this site that will contribute 1-2 articles/month. I have spoken with a number of interested parties, but particularly I am looking for people that want to have a voice and enjoy discussing / teaching concepts to a broader audience as a whole. For reference, last month had over 125,000 visits to the site from nearly 50,000 unique visitors and RSS subscribers. Whether you are out of work and looking to get your name out there, or established at a firm and just want to talk about investing, or possibly a lawyer that wants to promote business to his firm by discussing a topical issue on bankruptcy, we would love to have you. For those wanting to rename anonymous, I am obviously comfortable with such a move. If you are interested, please contact me at hunter [at] distressed-debt-investing [dot] com.

Update: For those asking what I am looking for in terms of writers, here is what I am thinking:
  • 2 distressed buy side analysts or restructuring professionals focused in the US
  • 1 distressed buy side analyst from Europe
  • 2 bankruptcy lawyers / attorneys that want to write about topical subjects as it relates to distressed debt investing
3) Speaking of the traffic stats above, starting in 2012 and to fund certain projects I will be working on across the sites, I plan on selling advertising on this site specifically. I would like to partner up with a company that not only can advertise here, but can also contribute meaningfully to our readers via a sponsored post that adds value to the community. If you or your firm are interested, please email me.




On The Benefits of Niche Specialization for Analysts

This past Friday and Monday, two conference calls were held by Vedder Price and Chapman & Cutler, respectively, along with other associated parties pitching American Airlines' debt holders to use their services in the ongoing American Airlines bankruptcy. Both calls discussed the experiences of the firms involved in previous airline bankruptcies, including certain legal "victories" they garnered for their clients. Both firms did a fantastic job presenting their case and in my opinion, both firms will inevitably perform substantial work for funds and other AMR / AMR EETC debt holders over the next two years.

One of the most popular questions I receive from clients when I work with them as part of our resume and case study services is: "Is it more likely for funds to hire a generalist or an industry specialist?" To be completely frank, I think this will vary from what firm you are talking about and the specific management skills of the CIO / Founder / Portfolio Manager as well as size constraints (small firms can't afford more than a few analysts). Many funds and other buy side organizations have been wildly successfully with either formula.

With that said, in my opinion, I believe over the next couple years you will begin to see more and more funds focus on hiring talent with specific industry or product specializations. This will be driven by four fundamental factors that I will try to tackle individually:
  1. The recently history of the fund management business becoming increasingly specialized
  2. An increasingly "global" viewpoint of managers
  3. The consensus view that big funds will dominate asset gathering over near future
  4. The decline of "Expert Networks"
The recently history of the fund management business becoming increasingly specialized

Through the 90s, the hedge fund business was synonymous with a few high profile fund names: Tiger Management, Quantum, etc. The concept of a retail focused hedge fund, or one focused on financials really was driven by two factors: 1) Tiger Management shuttering its doors releasing analysts with immense industry specific knowledge (and performance related numbers) to capital allocators, specifically fund of funds and former Tiger Management clients ready to seed these firms en masse and 2) The Global Settlement and other actions by Elliot Spitzer that seperated the research staff compensation from investment banking fees. What this did was dramatically reduce the compensation of MANY Wall Street analysts. These people, with immense knowledge and contacts in their respective industries, again left en masse to the hedge fund industry which could leverage their talents to focus on specific strategies. Similar things are also occuring in the private equity business where former partners leave their current established shop to set up an industry focused fund.

I do not know if a study has ever been performed that tries to bifurcate performance of industry focused funds returns with more generally focused funds, but I will comment that in my opinion, at least for funds sub $2 billion dollars, the capital raising is much easier being a niche focused fund. I will talk about this a bit more further on in the post, but I believe after the financial route of 2002 and 2008, risk managers and risk management at large endowments and pensions are becoming more and more savvy in regards to overall portfolio composition. If I have ten long / short equity funds in my endowment, I can lay each and every one of them out to determine my overall industry exposure. Say each of those ten funds were massively overweight tech - this would be a serious cause for concern.

But if I go to an endowment with an insurance focused fund for instance, the CIO and risk managers of that endowment know exactly what they are buying into. Further, they can probably be more comfortable evaluating my prior stock selection skills versus an industry specific benchmark. One of the studies that private equity fund of funds perform before allocating to a specific manager is attribution of return per partner. If Partner A has generated all the return for the private equity shop relative to Partners B and C, that gives cause for concern. For an industry specific fund, attribution is much easier relative to a general fund that may have many analysts making many different decisions.

An increasingly "global" viewpoint of managers

Right or wrong, you can ask 8 out of 10 prognosticators on the stock market where returns will come from over the next 20 years, you will inevitably hear emerging markets. While I would never make such a bold statement, it is hard to argue that a long/shorts fund's investment options should be limited to U.S. base companies. First, most components of the S&P 500 generate substantial revenues and cash flow overseas and second, barriers to capital flowing in all sorts of direction are crumbling everyday. Despite political rallying around "protecting U.S. interests", we will most certainly see more foreign companies purchasing U.S. based companies over the next twenty years than we have in the past twenty years. Speaking of AMR, I would not be surprised if we saw the complete dismantling of the Federal Aviation Act which prohibits foreigners from owning more than 25 percent of an US airline.

If we operate under that assumption, then we must, as analysts know the major players in our respective industries not just domestically, but globally. This helps out in so many areas ranging from valuation (more comps!), gauging business trends, management reference checks, etc. I've always operated under the assumption that, all else being equal, the more people you know in an industry, the more value you will be to your portfolio manager. One thing I tell resume service clients to do is network with people in an industry they like to cover like nobody's business. If you cover the steel industry, and didn't attend Goldman Sachs' Steel Conference a few weeks back, and not walk away with 25+ business cards of management teams and fellow investors, you didn't do it right.

As buysiders, we are driven by one thing: Better returns for the appropriate amount of risk undertaken. And as fund management gets more and more competitive at the margins (as many articles have pointed out in recent weeks, alpha of the fund management business now is zero), more portfolio managers and founders will continue to broaden their scope internationally where competition is less fierce AND markets are more inefficient. We've seen Warren Buffett branch out internationally for the first time this past decade with comments from WEB that he wants to do more internationally. So will everyone else. And because of this, industry specialists, that can better survey their industries globally will be in high demand.

The consensus view that big funds will dominate asset gathering over near future

Whenever I hear the term "consensus view" I generally will run the other way as the consensus view is probably already priced. With that said, it's hard to argue what everyone has been saying for the past 18 months: That the majority of assets raised in the hedge fund industry will be allocated to the mega funds. While you may think this flies in the face of my point above on industry specialization, in my opinion industry specialization will be the path of least resistance for raising capital for new managers in the future. Say there are $100 dollars of incremental capital to allocate to hedge funds globally over the next ten years. If 70% of that money is going to the top 25 funds, the remaining $30 dollars is being scrapped over by 1000s of funds trying to differentiate themselves from the competition.

And while size will affect performance, if you are an emerging long/short fund with a general approach, it is VERY difficult to garner those investment dollars versus a large fund like Maverick that has dedicated investment teams focused on specific industries. This seems counter-intuitive until you think about the concept of index hugging of the mutual fund industry and how it too affects capital allocators in the fund management space.

Why do so, so many mutual funds deviate so little from their benchmark? I think the CFA Institute calls it the concept of 'herding.' I call it the "comfort of the consensus." Mutual fund manager, just like most high paying professionals waking up tomorrow morning want to keep their seat. By not straying too far from the index their relative returns will never look terribly bad, but they also will probably never look terribly good either. Similarly, the CIO of an endowment of fund-of-funds, will never really take big heat from his stakeholders (Board of Directors, or fund of fund investor) if he loses money in a fund like Tiger Global. Similarly, risk managers and compliance officers at these same institutions feels many many more times comfortable recommending an established firm, with many other name brand investors already invested, along with proper reporting, compliance, and back-office protocols relative to a start-up managers that may not have these luxuries.

They say the fastest growing job on Wall Street right now are compliance managers or Chief Compliance Officers. While almost certainly not a line item for many smaller firms, nearly every major fund has an entire compliance team. More and more, this is becoming a requirement for major endowments and pensions to invest in a certain fund. Further, with the adoption of Dodd-Frank, regulation is getting heavier, and whenever their is new regulation, there is need for new bodies to make sure the firm is in compliance with those regulations.

The decline of "Expert Networks"

For full disclosure, I have used expert networks in the past and will continue to use expert networks in the future. I think they do indeed serve a very specific need for parties (asset managers, consultants, law firms) looking for insights into a particular industry. It is unfortunate that the actions of a few people have tainted the general populace's viewpoint of this service. Even more unfortunate is that more and more, you are hearing funds being asked by potential institutional investors if they use any expert networks in their research protocol. While I do not know if this places a big red X on whether the institution will invest or not, it cannot be good.

The problem with expert networks of course are the margins. That may sound silly, but the margins in the expert network are mind-blowing. This is at both the company providing the overall service but also the experts themselves High margins attract any and all sorts of new comers and this can and has brought in people to the business that were ethically challenged and conducted themselves deplorably. While I may sound a little feisty here, it is simply driven by my opinion that a few bad apples has seriously hurt the business of so many people with unquestionable integrity and my "Utopian" idea that investing is really a game of skill of the mind, where each and every one of us are on a level playing field until we are not. And when you upset that delicate balance, you are putting me, and the thousands of other professional investors and millions of individual investors in a weaker, tenuous, and downright upsetting position.

With the decline/shaming of expert networks, the need for analysts with their own set of industry contacts (under the watchful eye of a compliance officer) has become even more important for differentiating your portfolio returns from the rest of the competition. In addition, I do believe you will begin to see more and more traditional research providers focused on industry and niche verticals (think Meredith Whitney) be in demand from funds looking to strengthen their industry analytic depth without risking the issues that have enveloped the expert network industry over the past 18 months.


I've been meaning to write about this for the past couple months and the aforementioned conference calls from AMR brought the issue to front-center. I can only imagine how busy dedicated credit analysts from the sell-side have been in the wake of the AMR filing. Even I have received nearly 50 emails from investors discussing my AMR post from last week. Analysts and fund managers thirst for this type of specialized information in the hopes of getting a leg up on the competition.

If I had one recommendation for all those looking for a job at a fund (whether you be out of work currently, on the sell side, at another fund) in a tough environment: Learn an industry like the back of your hand. Be able to tell me the names of each and every CEO and CFO across the industry and what their Modus Operandi in terms of management and capital allocation are. Be able to contact many people in the supply chain to get a sense of what's going on on the ground for distributors, buyers, etc. Know the customers and how companies are differentiating themselves from one another whether on price, service, quality, etc. Know the Wall Street analysts to get an understanding of the consensus view and be able to tell me why and how they are wrong. Even better, know other buy side analysts and understand their views and why THEY are also wrong. Like Li Lu has said, evaluate and know the business like you inherited it. I think by doing this, you will make yourself much more valuable and marketable for the years to come.



Distressed Investing Conference Notes: Part II (including Wilbur Ross comments on shipping sector)

Last week, we reported notes from the Beard Group's 18th annual Distressed Investing Conference. Distressed Debt Investing contributor Josh Nahas, Principal of Wolf Capital Advisors, a Philadelphia based investment advisory firm focused on distressed debt and corporate restructuring, was in attendance. Here is more notes from the conference:

Baggage & Benefits: Current Issues in the Ownership of Distressed Debt and Bankruptcy Claims

  • Paul N. Silverstein, Panel Moderator, Partner/Co-Chair Bankruptcy & Restructuring Practice, ANDREWS KURTH LLP
  • Geoffrey A. Richards, Group Head, Special Situations and Restructuring, WILLIAM BLAIR & COMPANY L.L.C.
  • Jane Sullivan, Executive Vice President, EPIQ BANKRUPTCY SOLUTIONS
The first topic discussed was credit bidding and the Philly News and Palco decisions and how those decisions were unfavorable to secured creditors who, prior to those rulings, had always assumed to have an absolute right to credit bid except in the case of malfeasance. Section 363(k)of the bankruptcy code allows for credit bidding except for “cause” which the 3rd circuit in Philly News went to define broadly, not just a bad act.

However, in In re River Road Hotel Partners LLC the 7th Circuit affirmed the bankruptcy court’s ruling, rejecting the debtor’s bid procedures motion on the grounds that it precluded credit bidding. In that case, the court took the same approach as the dissenting opinion of Judge Ambro in Philly News which was based on the principles of statutory construction. There is now a split between the 7th Circuit and the 3rd and 5th Circuits and the appellate circuits as to the interpretation of Section 1129(b)(2)(A)’s “fair and equitable” standard. River Road along with another debtor in a similar case RadLax have appealed the decision to the Supreme Court.

Issues relating to the risks of trading with Plan Support Agreements ("PSA") were discussed. One result is that creditor will be required to disclose exact amount of holdings. Counter parties need to know whether they actually hold title to instruments (assignment vs participation) and whether the securities are held currently or out on loan. It was recommended that if you sign a PSA it is best not to sit on the UCC because of potential conflicts in your fiduciary duties.

Next, the panel tacked the issue related to WAMU and post-petition interest. The panel viewed as a troubling and unsound decision where a ruling by Jude Walrath of the US Bankruptcy Court in Delaware held that creditors with a contract rate of interest (bondholders) of a solvent debtor were only entitled to Federal Judgment Rate on post-petition interest. In the opinion, she admittedly disavowed her previous statements in In re Quorum Healthcare Corp where she had upheld post-petition interest at the contract rate. She did uphold a contractual subordination clause between the Sr and Junior lenders that will require the junior lender to turn over their recovery to the senior lenders until the senior lenders have recovered their post-petition interest.

The panel all agreed that as a result, investors should be modeling base case recovery waterfalls in solvent debtor case assuming judgment rate not contract rate, at least for cases in Delaware until there is more clarity on the issue.

Perhaps the most disturbing and far reaching decision for distressed investors is Judge Walrath’s findings with regards to potential insider trading claims. In her ruling, Judge Walrath found in favor of the equity committee having a “colorable” claim of insider trading against members of a steering committee which had formed to negotiate a settlement with the debtor. The 4 fund group had established provisions for cleansing of inside information, and lifting of trading restrictions when negotiations had closed. The panel believed that this decision may significantly impact the ability and willingness of creditors to actively participate in negotiations with debtors. This could increase the time it takes to get a deal done in bankruptcy, as well increase the amount of money spent litigating, rather than negotiating.

The last issue the panel briefly touched on was Judge Kevin J. Carey’s decision to reject both plans in the Tribune bankruptcy. Carey said neither plan was confirmable but appeared to favor Tribune’s plan, labeling the competing plan as “speculative.” The issue surrounds Fraudulent Conveyance claims against those who financed the 2007 LBO of the company. There are questions surrounding the ability of the creditors to step into the debtor’s shoes and pursue the claims, since fraudulent conveyance actions are prosecuted by the debtor on behalf of the estate.

Transportation & Shipping: Investment Tips & Traps

  • Wilbur L. Ross, Chairman and Chief Executive Officer, WL ROSS AND CO. LLC (Pre-Recorded Statement)
  • Edward O. Sassower, Panel Moderator, Partner, KIRKLAND & ELLIS LLP
  • John P. Brincko, President, SITRICK BRINCKO GROUP, LLC
  • Mark Friedman, Senior Managing Director, EVERCORE
  • Daniel G. Montgomery, Managing Director, MESIROW FINANCIAL CONSULTING, LLC
  • Steven Strom, Managing Director and Global Head of Restructuring, JEFFERIES & CO.
Wilbur Ross opened with a 20 minute overview of distressed shipping sector. He spoke via a pre-recorded video as he was in Ireland meeting with regulators about his investment in Bank of Ireland. Mr. Ross spoke briefly about his investment in Navigator Holdings and Airlease, however he spend most of his time providing an astute overview of distressed shippers.

In the distressed shipping sector, he first noted that the majority of ships are financed by European banks which are under increasing strain and have dramatically curtailed lending. Shipping is already struggling due to the glut of ships that have come on the market from the mid 2000s boom as well as from declining economic activity. Moreover, shipping is still a highly fragmented industry with few barriers to entry. There are a large number of charter operations with 1 or 2 vessels who compete aggressively on price. He noted that currently shippers require $4 of assets to generate $1 of revenue, not a recipe for good returns on capital. With charter rates down over 45% from their 2007 peak, Mr. Ross predicted that the market would not reach equilibrium for at least another year if not more.

As a result of these factors Mr. Ross predicted that the next couple years would be difficult for shippers and that the way the industry finances itself would be fundamentally transformed and that private equity and alternative investors would play a significant role. He believed that banks were going lower the LTVs that they lend against to the 50% range while they previously had been closer to 80%. He noted that a great deal of ship financing over the last several years came from German KG tax shelters, but indicated that this source of funding was not likely plays as big a role going forward.

In addition, he felt that the current opaque corporate structures where operators are competing against their public company owners would need to change and that the business would need to become more transparent. Mr. Ross predicted there would be opportunities for those who funds willing to take a long view and capable of dealing with the multi-jurisdictional issues and untangling the complex corporate structure.

Moving to the panelists in attendance, John P. Brincko, President of Sitrick Brinkcko who specializes in the trucking space spoke on the current problems facing the sector. He pointed out that the business has become heavily commoditized, is highly fragmented with many independent owner/operators and has little pricing power. To make matters worse many of the truckers, including YRC which went through a restructuring are saddled with expensive union contracts. He felt the companies with expensive labor contracts, and particularly YRC, would likely need to file for bankruptcy to reduce operating costs and remain competitive.

Other panelists noted the free fall bankruptcies of Omega Navigation and Marco Polo and said those cases could influence future restructurings in the shipping space. Steve Strom of Jefferies cited Omega as an example of a foreign shipper filing in the US as a good test case. (Jefferies is advising the debtor). Mark Friedman of Evercore noted that there are a large number of publicly traded shippers priced under $10 per share with 12-15 shipping companies trading at $2. He thought many of these names could be good short candidates.



Beard's 2011 Distressed Investing Conference

Earlier this week, the Beard Group, publisher of Turnarounds & Workouts and the Troubled Company Reporter held the 18th annual Distressed Investing Conference. Distressed Debt Investing contributor Josh Nahas, Principal of Wolf Capital Advisors, a Philadelphia based investment advisory firm focused on distressed debt and corporate restructuring, was in attendance. Over the next week or so, we will be providing notes from the various panels at the conference.

The first set of notes focuses on cross-border insolvency, with a particular focus on Canada. Panelists included:
  • Harold L. Kaplan, Panel Moderator Partner/Leader Corporate Trust and Bondholder Rights Team, FOLEY & LARDNER LLP
  • Allan S. Brilliant, Partner, DECHERT LLP
  • Robert J. Chadwick, Partner/Member Executive Committee, GOODMANS, LLP
  • Nigel D. Meakin, Senior Managing Director, FTI CONSULTING
  • Stuart Swartz, Senior Vice President, COMPUTERSHARE TRUST COMPANY OF CANADA
  • Claudia R. Tobler, Counsel Bankruptcy and Corporate Reorganization Department, PAUL, WEISS, RIFKIND, WHARTON & GARRISON LLP

Cross Border Insolvency

A multinational distressed company’s ability to maximize its restructuring potential requires careful planning and an understanding of the issues raised by competing and potentially co-equal insolvency regimes.

When to file, and whether a deal can be reached out of court is important. When to pull the plug on negotiations for successful out of court restructuring is influenced by regulatory regime. In Canada, the Canada Business Corporations Act allows for holdouts in an out of court restructuring to be bound by a 2/3 majority vote. Makes out of court deals easier and deals with free rider problem. In US, most consensual deals will not work without 90% of holders or better due to free rider problem.

Where to file is heavily influence by DIP lending capacity. Also, US creditors have aversion to CCAA in Canada because there is no UCC. As a result, both Smurfit and Abitibi/Bowater resulted in both concurrent CCAA and Ch 11 proceedings which increased the cost to the estate dramatically. The alternative is a CCAA action with a corresponding Ch 15 filing in the US.

A CCAA with a corresponding Ch 15 filing would allow for a much lower estate costs as administration fees in Canada are much lower compared to US filings according to the panel. Several panelists noted that if the role of a monitor was better understood there may be less aversion to using CCAA and a Ch 15. The monitor is chosen by the Debtor, which to some in the US gives the appearance of impartiality. However, the monitor is tasked handling many of the matters the UCC would tackle in a restructuring.

Since most of the negotiations between the monitor and the debtor happen behind closed doors, the monitor is wrongly viewed as not being a strong advocate for creditors. However, according to panelist Nigel Meakin of FTI the monitor actually can be a forceful advocate and usually the debtor will come to terms with monitor, because if the monitor appeals to the court, judges will generally defer to the monitor’s decision.

Another difference between US and Canadian insolvency is the role of indenture trustee. The Indenture Trustee does not play the same forceful role or have the same fiduciary obligations as US indenture trustees do. Stuart Swartz, of Computershare the largest indenture trustee in Canada highlighted the top 10 difference between US and Canada indenture trustee.
  1. Indenture Trustees unfortunately still cannot claim diplomatic immunity when acting on cross-border deals.
  2. When working with an indenture trustee on a cross border default, get the counsel and parties collaborating as soon as possible.
  3. In Canada, rating agencies view indenture trustees differently than in the US.
  4. Canadian’s don’t do Committees like in the US.
  5. In Canada, there is no need to act unless funded and provided with an indemnity in advance.
  6. Industry practice in Canada and US shapes discussions as does market size and number of industry players. Trustees are expected to be much more active in the US than in Canada. Other regions vary as well. The use of discretion by the trustee will vary greatly in each region.
  7. Canadian trustees don’t create conflicts due to lending situations (re: Successor Trusteeships are more common in the US due to these conflicts).
  8. Trustees are advocates and not experts. This is why we retain the right to hire and rely upon advisers
  9. Regardless of jurisdiction, it is the overall goal of the indenture trustee to maximize return of investment to the holders when acting in a default situation.
  10. As with this presentation, indenture trustees are never given enough time when first called upon. Please reach out as soon as you can.
The panel then tackled some case studies starting with Qimonda, a German bankruptcy with concurrent Ch 15 proceedings. Debtor sought to invalidate intellectual property licences in order to re-auction them and gain more value to estate. German courts would allow, however, objections in US Ch 15 proceedings court would not allow them to do so based on Section 365(n) of BK Code United States Bankruptcy Court for the Eastern District of Virginia, holding that fundamental U.S. public policies of fostering technological growth and innovation, determined that the protections of section 365(n) apply to licensees of a foreign debtor’s U.S. patents.

The Court held that by a joint reading of sections 1521(a)(7) and 1522 of the Bankruptcy Code, strongly favored the application of section 365(n) with respect to the U.S. patent portfolio of Qimonda, a foreign debtor, and (b) permitting a foreign debtor to use foreign law in a chapter 15 case to non-consensually terminate various U.S. patent licensing agreements would be “manifestly contrary to the public policy of the United States” pursuant to section 1506 of the Bankruptcy Code.

The Vitro case was then discussed. Vitro SAB is a glass manufacturer with US subsidiaries and $1.2bn in US$ denominated unsecured debt. The company filed a “pre-pack” under Mexican statute by creating post default $1.9bn in inter-company loans to dilute bondhodlers and vote in favor of debtor’s plan. Per the indenture, inter-company loans were expressly subordinated to the bonds. However, the court allowed the inter-company claims to be used for the purposes of skipping the preliminary phase of case and filing a pre-pack. The Debtor then proposed a plan that invalidated the bondholders subsidiary guarantees and heavily favored the existing equity holders at the expense of legitimate creditors. A concurrent Ch 15 was also filed in the US.

A Conciliador or Conciliator was appointed by the Court tasked with reaching a settlement between the noteholders and debtor. The settlement proposed by the Consiliador put the bondholders in a worse position than before and was rejected.

Meanwhile litigation in New York was initiated by Wilmington Trust in its capacity as indenture trustee with respect to Vitro’s 2012 and 2017 bonds with a combined $1 billion outstanding. These securities were guaranteed by many of Vitro’s US subsidiaries as well as others and the indenture expressly acknowledged that it was governed by NY law and that “any rights and privileges that such Guarantor might otherwise have under the laws of Mexico shall not be applicable.” Wilmington argues as a result of NY Law governing the indenture that the guarantees cannot be avoided by the holding’s insolvency proceeding in Mexico. A ruling from the court in NY is expected soon. The belief is that the NY court will rule in bondholders favor and thus forcing Vitro back to the bargaining table.



Distressed Debt News / Research - AMR Bankruptcy

This morning, AMR Corporation ("AMR"), and its subsidiary American Airlines, Inc. filed for bankruptcy protection in the Southern District of New York. For those looking for the docket, it can be found here:

To say that this was a surprise to the market would be a bit of an understatement. To give you a sense of how far out of left field the timing of the bankruptcy filing was, the December 2011 CDS traded yesterday at 5.5 - 8.5 points up front. It closed today at 83 points up front. If you polled the majority of sell side analysts out there, they would have told you that AMR had the liquidity to survive at least until mid-2012 and possibly beyond.

Call me a sicko, but to me, AMR's capital and corporate structure is a thing of beauty to the distressed analyst. To put it simply: There are so many different securities to play ranging from EETC, to secured / unsecured municipal debt, to converts, to the general unsecured pool, to pass through certificates, etc. Each with their own recoveries requiring discrete analysis. It is majestic.

Here is an example. AMR has over $3 billion dollars in municipal debt. You can actually see every single security (along with other publicly traded debt) starting on page 48 of this document: AMR Bankruptcy Affidavit. Each of these securities could be unsecured or secured by leases on gates or owned maintenance facilities. A good friend pointed out that CUSIP 01852LAB6, an Alliance Texas Airport Authority Bond, with ~$125M outstanding was due to be paid this coming Thursday. It's unsecured. Pain.

Here is the first day affidavit:

As of now, I will be completely honest and point out that the majority of my time over the past few months (since the AMR bankruptcy scare in October), has been on the EETC side. I will end the post with some overall thoughts on the controversial 7.5% notes secured by international routes and some questions on the general unsecured pool. But for now, let's dig into EETC securities.

EETCs (Enhanced Equipment Trust Certificate) are secured securities backed by the financing of individual airplanes. When an airline or lessor like ILFC purchases a plane from Boeing or Airbus, they finance the purchase. They do this on a number of planes. These financings, from the pool of purchased planes, are then packaged equipment notes, pooled, and then placed into a EETC structure and sold to institutional investors. These securities are classified as pass through securities because as each individual equipment note backed by an airplane financing pays interest and principal payments, these payments are passed through to the overarching EETC to pay interest and amortization payments.

Depending on the individual structure, EETC are tranched into A, B, and C tranches. The A's will be the senior piece of paper and will recover first in a bankruptcy / default scenario (cross-subordination). With that said, the A tranches will almost always have the longest weighted average life as amortization payments of the EETC go to pay the C, then the B off first. Loan to values scale with the tranches, so an A tranche may be marketed at 60%, a B tranche at 75%, and a C tranche at 90%. Because of this, as well as the contractual seniority, A's come with a lower coupon despite the longer tenor. A G tranche in EETC land refers to a EETC tranche wrapped by the likes of Ambac or MBIA.

A final quick note, on amortization: all amortization and principal pay downs are not created equal. There are instances when a EETC structure will contain a lot of great planes, but also a lot of terrible planes. An investor should recognize that each underlying financing references an individual aircraft. Those financings have different maturities and the LTV of a EETC structure can change dramatically if those equipment notes backing good planes mature first (i.e. you are in a stub of bad equipment notes)

Each EETC is different, and newer vintage EETC have protective benefit to lenders in the form of cross default and cross collateralization. If AMR defaults on one equipment note backing an airplane in a EETC, the cross default means ALL equipment notes are triggered in that same EETC. Cross collateralization means that deficiencies in one equipment note can be offset by gains in another equipment note. These concepts are very important to the AMR bankruptcy as the 2009-1, 2011-1, and the 2011-2 EETC structures feature both cross default and cross collateralization provisions.

Another unique characteristic of the EETC structure is referred to in the market as a "liquidity facility." These facilities, backed by highly rated banks, provide for the payment of interest on the various tranches of the EETC for 18 months. This allows creditors that have taken ownership of rejected planes time to refurbish, provide maintenance for, and re-market (sell) planes with the intended purpose to avoid distressed, under-the-gun sales.

Finally, and topical, as AMR has filed for bankruptcy are the concepts of 1110 (a), 1110 (b), and 1110 (c). Under 1110(a), aircraft have their own place in bankruptcy law in that debtholders can take back the aircraft 60 days after a bankruptcy filing if airline does not cure the default (i.e. pay interest and amortization on the note). This is where the concept of affirm or reject comes in to play and where investors can start differentiating themselves in terms of the knowledge they bring to a particular bankrupt airline's situation. The aforementioned 1110 (b) can be thought of as a renegotiation between the airline and the pass through note holders (and involves adequate protection payments for use of plane). And 1110 (c), or a rejection, is when a plane is returned to the lender.

There are more nuances to the structure (purchase option for subordinate tranches, adjusted expected distributions, CODI claims, etc), but for now, this will do, and as AMR exercise their right to accept or reject collateral in various structure, we can flesh out the details. In its letter to aircraft creditors, AMR said this:
We cannot afford to retain all the aircraft currently in the American and American Eagle fleets at their current rates, and so we have no choice but to make substantial reductions in the cost of the aircraft which we retain. Moreover, in view of the large number of aircraft we have on order from Airbus and Boeing, we also seek to accelerate our fleet renewal strategy and, as a result, we do not require the use of all aircraft currently in our fleets. Additionally, to conserve our liquidity, subject to the requirements of the U.S. Bankruptcy Code, during the 60-day Section 1110 period, we plan to make payments when due of aircraft rent and mortgage principal and interest payments only on certain aircraft in our fleets.
To put it lightly, AMR, out of all the domestic carriers, has an extensive order book. Here is the disclosure from the most recent 10Q

Here is the playbook for AMR during this bankruptcy:
  • Reject old, fuel inefficient airplanes (MD 80s) that will be replaced by the 737-800 family (not all will be rejected, but most will)
  • Renegotiate every labor contract out there to make yourself more cost competitive with the industry. In fact, AMR actually put in a graph in the aforementioned affidavit displaying how weak their margins are to competitors
  • Rationalize your network in terms of routes and gates (i.e. leave Chicago for instance). This may require asset sales in addition to flat out defaulting on municipal debt.
  • Reject the pension and put it to the PBGC
The question then for investors becomes: Where can I get the best bang for my buck? In EETC land, the question of reject or accept under 1110 becomes paramount. For instance, the 6.977% notes are the 2001-A vintage. They are trading in the mid 50s. There is $177M bonds outstanding. Backing those bonds are 32 MD-83s delivered in the last 90s. To figure what this EETC tranche is worth, you need to take a number of things into consideration:
  • Will they accept or reject these planes? Maybe they accept a few and continue paying interest on the underlying equipment notes and reject all the rest. As every one of these MD 83s are owned by Boeing, it is more likely they reject than accept (airlines, for various tax reasons, are somewhat reluctant to reject planes they own). But if you believe they will accept a lot of this collateral, you would be more bullish all else being equal
  • If they do reject planes, how much are those planes worth after they pass maintenance tests and monies are spent for re-marketing (you could also melt the planes for steel value)
  • If the amount of debt is not covered by the asset sale process, you would have a general unsecured claim to the AMR estate. You then need to figure out how much that claim is worth and add that to your recovery.
  • A smaller, but important consideration: Interest will be paid on this EETC for 18 months via the liquidity facility. This paid interest becomes a super senior claim over your A-tranche (i.e. if the liquidity facility provider pays out $100 dollars in payments, $100 dollars of debt is now ahead of you in the waterfall). This can be important in very low dollar price bonds as you are creating a very cheap option after deducting the present value of interest payment
Determining if a plane will be rejected or accepted is more of an art of science. Many, many factors come into play here include (but not limited to):
  • Type of structure the equipment note backing the plane is a part of. For instance, an airline may be less likely to reject a plane backed by an equipment note in a EETC that has cross default provisions, all they could lose all planes in that structure
  • The important of the plane in relation to the overall fleet and future fleet build out plans. As noted above, AMR is purchasing a significant number of 737-800s, meaning they are less likely to reject these planes.
  • The unique aspects of a plane in terms of its range and capacity. If an airline used to have significant need for wide-body planes, and now doesn't because of route / slot / gate changes, they may be more likely to reject those planes
  • The maintenance schedule of a particular plane may be onerous in the coming years and be a cash flow drain on the airline which means its more likely to be rejected
  • Cost of financing the underlying equipment note versus market rate. This can be extended to the overall EETC structure - i.e. could AMR go out in the market today and get a better deal for some of their high coupon EETC structures?
The value of a plane in a re marketing exercise is really a function of supply and demand. One thing I look for are planes that many different airlines use. Some planes only fit 3-4 carriers making them harder to sell into the broader market place. Demand for 737-800 is quite high and queue times for delivery is 5-6 years out, meaning these planes would easily be remarketed. There are a number of appraisal companies out there that will tell you what they think each and every kind of aircraft out there is worth today, next year, and 5-10 years out. As a rule of thumb, I lop of 15-25% off the top on these appraisals for a sanity check.

With all that said, that is how you approach AMR's EETC structures. I definitely think some are interesting and are high current yielding pieces of paper.

Over the next few weeks, I will be spending time digging through and laying out every piece of paper that I can find to ascertain market opportunities. As noted above, there is A LOT to work through, and one analyst could spend an entire year or three just understanding each underlying municipal, EETC, Pass Through, Secured, etc piece of paper. With that, I'll end the post with a few questions that linger in my mind that I will try to tackle over the next week (and if you have any thoughts, please feel free to email me to discuss)
  • What is exactly the pension underfunded status and how large an unsecured claim will the PBGC put to the estate? What effects do recent changes to pension legislation as it pertains to airlines have on this number?
  • If the liens backing the 7.5% were not perfected, do the unsecured's make a case that they should see benefits from that collateral? What really is the value of that collateral? $20M per slot pair according to Air Canada's recent valuation for Heathrow. But what about Japanese, where AMR is weak, and China routes?
  • The 13% Notes, while not a traditional EETC structure, kind of scare me. Does it make sense to reject slightly older 737-800s to restructure a small, but very high cost piece of paper? The 10.5% Notes are a slightly different story - and with such a large contingent of 757-200s in the structure, which AMR has admitted they are rationalizing next year, are equally frightening
  • Who is going to own the equity in this thing when all is said and done? A hodge podge of unsecured creditors including the PBGC? How does this affect the NOL, which I believe is around $8 billion dollars.
And these are really just structural questions. The big question on everyone's mind is: After all is said and done, what kind of EBITDA margins are we talking here? Is it 5%? 7%? Given the size of the revenue line here a 100 basis point move in margins is massive when you capitalize it a 4-5x.

This is going to be a fun one. I can definitely say that I have more than enough to be working on in distressed debt land with the recent filings of AMR, DYN, PMI, and MF, along with a number of legacy situations. Great time to be involved in distressed debt investing.



What would you like to see more of on Distressed Debt Investing?

Each year, I try to gauge readers' interest on what they would like to be seeing more of on the blog. This year, I created a new poll that I think will give me a good idea what people want me to focus on in the coming months.

Please take the time to make one selection below. Or, better yet, fill in a suggestion for me that I may have missed. I will take the reader (+ a guest) with the best suggestion out for dinner in New York City in 2012. Just remember to include your email address in the answer box (don't worry - only I will be able to see your suggestion + email addy).

As always, thanks for your time and support!




Advanced Distressed Lesson: Claim Value, OID, and Make-Whole Provisions

Earlier in November, the bankrupt Great Atlantic & Pacific Tea Company ("GAP") announced a deal that would enable the company to exit from bankruptcy. Financed by prominent stakeholder (equity and debt) Yucaipa, well-regarded event driven fund Mount Kellett, as well as funds managed by Goldman Sachs Asset Management, GAP was to receive $490 million split between new second and third lien notes as well as new equity to facilitate the company exiting from bankruptcy.

One of the beneficiaries of this plan and new investment was the company's existing 11.375% Second Lien Senior Secured Notes. A little less than a year ago, we noted our interest in the same security: GAP Bankruptcy and Comps. As you can see from the below chart, in spite of a stagnant U.S. economy, a choppy high yield market, and unrelenting European malaise, this security has delivered a solid return to its investors:

With that said, Wells Fargo, in its capacity as trustee for the 11.375% Senior Secured Notes, and the ad-hoc group of Senior Secured Note Holders (who hold 69.5% of the outstanding principal of the notes) filed a limited objection to the capital raise.

According to the most recent statement of Brown Rudnick, counsel to the ad-hoc consortium, members of the ad-hoc group as of November 11th, are:
  • ALJ Capital Management LLC
  • AQR Capital Management, LLC
  • Artio Global Management LLC
  • Barclays Capital
  • Capital Ventures International
  • CNH Partners LLC
  • Davidson Kempner Capital Management LLC
  • Guggenheim Partners, LLC
  • Royal Capital Management LLC
  • Visium Asset Management, LP
  • Whitebox Advisors, LLC
I have pasted the limited objection below. It should be noted that on November 14th, Judge Robert Drain ruled that the financing, as currently contemplated may go forward, irrespective of the objective. That being said, the Disclosure Statement hearing is to be held in the middle of December, and the arguments and merits note holders objections may come up again at that hearing.

Here is the jist of the objection: The current securities purchase agreement with Yucaipa, Goldman Sachs, and Mount Kellett provides that secured note holders are too receive cash OR replacement second lien notes in an amount equivalent of their allowed claim. In addition, the plan is able to cramdown the Second Lien Notes to accept whichever way they are treated (cash or new notes). This is important in that the amount of new money coming in would change dramatically if the Second Lien Noteholders receive new notes instead of cash.

Why would the plan contemplate such treatment? According to the objection:
The “cramdown option” in the SPAs is designed solely to exert leverage over the Secured Noteholders in resolving the amount of their claims. Specifically, the Secured Note Parties have asserted, as part of their claim, amounts due under their indenture (the “Secured Notes Indenture”), other than principal and accrued interest, upon redemption of the Secured Notes prior to their initial maturity date – colloquially referred to as the “make-whole” claim. Upon information and belief, the Debtors and/or the Investors dispute the “make-whole” claim. If this is indeed the case, the Secured Note Parties submit that, in the interests of transparency for the Court and all constituents, the Debtors should disclose and take steps to resolve that dispute, rather than proceeding with an amorphous, half-baked “cramdown option” that may call into question whether the deal the Debtors are asking this Court to approve is indeed the deal that will ultimately go forward – or in reality is less than half of the deal.
And this is where it gets interesting: What is the value of the allowable claim of the Senior Secured Note Holders? Again from the objection we read:
Significantly, the amount of principal and accrued interest owing to the Secured Noteholders is in excess of $300 million, even before including other amounts to which the Secured Noteholders are entitled under the Secured Notes Indenture (Those other amounts include, inter alia, default interest and interest on overdue interest pursuant to Section 4.01 of the Secured Notes Indenture, a “make whole” premium owing upon redemption of the Secured Notes prior to August 1, 2014 pursuant to Section 3.07, and reimbursement of the Secured Notes Trustee’s expenses (including professional fees and expenses) pursuant to Sections 4.22(e) and 7.07.)
First off, let's tackle the OID issue in this case. The 11.375% Notes were issued in August 2009 at a price of 97.385% of par. The difference between 100 and 97.385 is the original issue discount or OID for short. OID amortizes through the life of the security. As was debated and ruled on in 2007 during the Solutia bankruptcy, secured debt issued at a discount is not entitled to the entire par amount of their claim. Instead: "a note issued at a discount is not allowable for its face amount. Rather it is allowable at the face amount less the unaccrued portion of the OID."

Then comes the issue of whether the security is over or undersecured. If the security is undersecured, the commencement date of the bankruptcy would essentially be the stopping point of accretion for the OID. If the security is oversecured, and post-petition interest has been granted, it makes sense that the OID would continue to amortize during the bankruptcy process through the effective date of confirmation; though this was never technically ruled on during the Solutia bankruptcy.

In GAP's bankruptcy, we are dealing with the latter. In rough numbers, there was 2.615 of OID for the 6 year maturity of the notes. The bonds were issued on August 4th 2009, GAP filed for bankruptcy in December 2010, and the confirmation hearing is set for February 6th, 2012. This means roughly 40% of the OID will have amortized by the confirmation date or 1.1 points. Face claim is thus 1.1 points + issue price (97.385) ~ 98.5.

Then, we need to calculate accrued interest on the security. The coupon is 11.375% annually or semi-annual coupons of 5.6875 points. The last coupon was on August 1st, 2010 (with coupons coming on February 1st and August 1st). With a February 6th confirmation date, there would have been 3 missed interest payments (Feb 2011, Aug 2011, Feb 2012). But according to the indenture, "Interest will be computed on the basis of a 360-day year of twelve 30-day months." There will have been 18 months since the last coupon meaning accrued interest would be ([1+(11.375% / 12)] ^ 18) - 1 or 18.5 points of accrued interest for the claim. At this point we have a total claim value of 98.5+18.5 ~ 117.

Now this is where things get really interesting, and probably deserve its own post. You will remember that the secured note holders are entitled to a make whole premium. According to the indenture:
Prior to August 1, 2012, the Company may redeem the Notes at its option, in whole at any time or in part from time to time, upon not less than 30 nor more than 60 days’ prior notice electronically delivered or mailed by first-class mail to each Holder’s registered address, at a redemption price equal to 100% of the principal amount of the Notes redeemed plus the Applicable Premium as of, and accrued and unpaid interest, if any, to, the applicable redemption date (subject to the right of holders of record on the relevant record date to receive interest due on the relevant interest payment date).
The capitalized Applicable Premium is then defined in the indenture as:
“Applicable Premium” means with respect to any Note on any redemption date the greater of (i) 1.0% of the principal amount of such Note and (ii) the excess (if any) of (a) the present value at such redemption date of (1) the redemption price of such Note at August 1, 2012 as set forth under Section 3.07(c) plus (2) all required interest payments due on such Note through August 1, 2012 (excluding accrued but unpaid interest), computed using a discount rate equal to the Treasury Rate on such redemption date plus 50 basis points over (b) the principal amount of such Note.
In standard market parlance, T+50 before August 1st, 2012. The aforementioned penalty under Section 3.07(c) is 105.688% meaning an extra 6-7 points (105.6 + interest from Feb-August at T+50) of claim value to the Senior Secured Note Holders.

Make wholes (and call protections) for that matter are widely debated topics in the bankruptcy world. The three cases that are pertinent to the discussion (and debate) are Premier Entertainment, Calpine, and Chemtura. Rather than post a wildly lengthy post on the topic, I am going to direct readers to a series put on by the Weil Bankruptcy Blog that does an AMAZING job covering all details from each case (not for the feint of heart):

It should be noted that in the objection to the securities purchase agreement, the Second Lien note holders pointed to the decisions in Chemtura and Premier Entertainment:
The “make-whole” claim is based on Section 3.07 of the Secured Notes Indenture, which provides for the payment of a premium, based on a formula, to the Secured Noteholders in the event that the Debtors redeem the Secured Notes prior to August 1, 2014. “When a loan is redeemed before maturity or (sometimes) upon default, a make-whole provision requires a borrower to pay a premium to compensate the lender for the loss of anticipated interest that might result.” In re Chemtura Corp., 439 B.R. 561, 596 (Bankr. S.D.N.Y. 2010). Pursuant to Section 506(b) of the Bankruptcy Code, an oversecured creditor is entitled, as part of its secured claim, to “interest on such claim, and any reasonable fees, costs or charges provided for under the agreement or State statute under which such claim arose.” 11 U.S.C. § 506(b). “In general, a prepayment premium is recognized as encompassed in the term ‘charge.’” In re Premier Entm’t Biloxi LLC, 445 B.R. 582, 618 (Bankr. S.D. Miss. 2010); see also In re Imperial Coronado Partners, Ltd., 96 B.R. 997, 1000 (9th Cir. BAP 1989) (a “prepayment premium is clearly a ‘charge provided for under the agreement’” under which such claim arose)). The Secured Note Parties reserve all rights with respect to the assertion of the “make-whole” claim.
It remains to be seen what will be the true "allowed claim" when the ink is dry on the finalized disclosure statement and bankruptcy plan. Both parties (the debtors/junior creditors and the Senior Secured Noteholders) are somewhat jockeying for position and ultimately, I believe, some sort of settlement will be reached. It is hard to handicap the whole "cash or new securities" relative to the disclosure statement on the table, but its hard to imagine the existing Secured Noteholders get stuffed with new 2nd liens and not fight relentlessly for different treatment. But that is why the 11.375% notes are not trading at a higher dollar price: the inherent uncertainty of a wildcard treatment in the plan.



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.