Book Recommendation - Aerotropolis: The Way We'll Live Next

People often ask me what books I am currently reading. While you can always see some of the books I am working through in the right sidebar, I thought this recommendation in particular deserved its own post.

One book I just finished reading was Aerotropolis: The Way We'll Live Next. Authored by a great friend of mine, Greg Lindsay, the book explores the impacts of globalization and its effects on the development of cities and consequently, how all of us, as global travelers, will do business. For the last fifty years, we have lived our lives with airports on the peripheral of the city. New Yorkers like myself abhor and fear the commute to JFK or Laguardia on a busy weekday. In the future, Greg posits that city development will be flipped upside down and airports will become the beating heart of the city, rather than on the periphery.

The book argues that air travel will become increasingly more important in our daily lives. I agree 100%. As capital continues to flow more freely from one geography to the next, investors will rely more and more on "on-site" due diligence rather reading SEC filings or annual reports. Specifically, as emerging markets will most surely grow faster than the domestic economy, and the competition for investment dollars heightens, the best hedge funds and investors will be traveling across the globe, turning over every stone to find the best risk-adjusted returns for their clients. And because of this increased global travel (and investing is only a fraction of the pie), we have to reconsider the "traditional way" cities have evolved and embrace a new paradigm for the 21st century.

I highly, highly recommend "Aerotropolis". It is a fascinating read full of anecdotes and commentary that are eye-opening and will make you rethink the way we will do business throughout the rest of the century.


Howard Marks' Speech Notes

Here at Distressed Debt Investing, we love everything and all of Howard Marks. Today, the Inoculated Investor has put up notes from a recent speech Howard Marks gave to the UCLA Student Investment Fund. Enjoy!



Greenstone Value Opportunity Fund Annual Letter

About a year ago, we did one of our first emerging manager interviews with the team at Greenstone Value Opportunity Fund. Notably, one of their largest positions at the time was Tronox, which was a moonshot (both the debt and equity) in the last few months of the year:

Last week, I received Greenstone's annual letter for 2010, which I've pasted in full below.

From my read, it looks like a pretty strong year for the team, maintaining a massive out performance versus the averages since inception. Here are some of my favorite quotes from the letter:
  • "The valuation criteria we are primarily concerned with have not changed: low multiples of free cash flow and/or EBITDA across the business cycle. When we say low multiples, we are looking for companies trading at less than 3-5x these multiples. In elevated markets we find that we have to search harder to find the multiples we are comfortable with, or we have to be more patient in letting the market come to us"
  • "Within the fund, we have been consistently trimming back our winners on the long side, while adding to our short exposure in an effort to lower the overall net long exposure as the markets have trudged higher. We are also sitting on a fairly healthy cash position. However, we’re very conscious of the fact that we can’t sit still praying for any particular bearish or bullish move to play out just because our portfolio is positioned to such a thesis. It is our job to continue to search for value no matter where the indices are trading, and to decide how much we wish to expose ourselves to an elevated market. We will continue to selectively add to our long book as we uncover mispriced opportunities, but it’s not our game to be climbing into bed just because everyone else is piling in." - (Editor's Note: My emphasis added. And stealing that one for when MBA students around the globe come to visit to hear my wit and wisdom)
  • "We currently have no credits, distressed or otherwise in the portfolio. As of mid January we are looking at one post emerging equity. While the valuation fits our criteria, finding a seller is proving difficult. We are always looking at the opportunity to invest higher in the cap structure when the upside/downside opportunity is compelling, and when we can emulate the same deep value focus on low multiples of free cash flow and tangible assets that we use in selecting long equities." - (Editor's Note: I've begged them to tell me the name, but their lips are sealed until they establish a full position. Here's hoping we can report on it when we get next quarter's letter. Nonetheless, like a lot of smart people, the team does not see much value in credit)
As always, if you come across an interesting letter to investors, please send it my way. All submissions are 100% confidential and I will never post a letter without getting the original author's permission.



2011 Wharton Restructuring Conference - Notes

The Wharton School of Business held its annual restructuring conference this past Friday at The Union League in Philadelphia. Writers from Distressed Debt Investing were in attendance and are pleased to bring you our summary of the events.

This year’s speakers included Ron Bloom the former Auto Czar, Jonathan Lavine founder of Sankaty Advisors and Shawn Foley Portfolio Manager US Strategy at Avenue Capital. Ron Bloom opened with a post-mortem on the GM and Chrysler bankruptcies and provided a much different perspective than they one currently held by the distressed hedge fund community at large. He highlighted some key facts largely ignored by those incensed by the government’s tactics, particularly in Chrysler. However, Mr. Bloom pointed out that both transactions were done as 363 sales where the government was the bidder and DIP lender. In addition, he addressed the issue of the differing treatment for financial creditors relative to trade and union creditors and pointed out that these are fairly routine even when the government is not involved and a buyer chooses to accept contracts with the seller’s workers and suppliers. In addition, he pointed to the steel industry restructuring in the 1980s and 90s (he was a major participant) where there was no government involvement and the unions and suppliers received far larger concessions. He provided an insightful look at the debate from the perspective of the government, the auto task force and the Debtors, as well as countering some of the hyperbolic rhetoric that had come from many in the distressed hedge fund community.

The overwhelming consensus among Panelists and Speakers was that we are experiencing a credit bubble and precipitous drop in risk premiums across asset classes, particularly in High Yield Bonds and Leveraged Loans. Nevertheless, both the Speakers and Panelists indicated there were opportunities to be had for discerning distressed investors. It was prophetic that the title of the conference was “Eye of the Storm” as we reached an all-time low on the High Yield Bond Index of 6.7% the day prior. Panelists were quick to point out that over last 18 months credit instruments have rallied across the board and yet the larger economy has been stuck with persistently high unemployment and a lackluster growth. The consensus was that 6.7% was far to low a yield for HY bonds, even thought it is not an all times low on a spread basis, and that it did not portend well for those long HY at these prices.

A key take away from the conference was that the credit markets cannot continue at these levels divorced from what is viewed to be a fundamentally unsound economy in the US and Europe. Steve Moyer of PIMCO pointed out that the short-term outlook for 2011 is quite bullish given that there is a very light maturity schedule in 2011, QE2 is flooding the markets with cheap money and there is favorable fiscal policy due to the extension of the bush tax cuts and the payroll tax holiday.

The longer-term outlook gives cause for apprehension. Some of the concerns evidenced were: the large maturity wall between 2012 and 2015 which is currently comprised of debt trading well below par and unlikely to be refinanced; earnings going up against much tougher 2010 comps in 2011, large fiscal deficits and federal debt in the US combined with state and municipal debt; US bank balance sheets with large amounts of distressed and defaulted debt marked as hold-to-maturity with bid ask spreads so far apart that it is not getting worked off; regional banks sitting on commercial real estate loans that have been amended and extended that are likely to be the next shoe to drop in terms of debt restructurings; and European Sovereign Debt concerns along with skepticism regarding European bank balance sheets.

With respect to the US credit markets, panel participants shared the view that we are nearing a top and that there will be a second distressed wave in the not so distant future. An interesting term was used for current state of bank amendments, “Amend and Pretend”, indicating that there is still an unwillingness on the part of banks to acknowledge certain problem credits. Panelists noted that DIP spreads have tightened dramatically as commercial banks have re-entered the market and new non-bank participants have also made an aggressive push. The Distressed Hedge Fund Panel participants lamented the return of some of the worst practices such as HoldCo PIK dividend recaps and the triumphant return of cov-lite deals so shortly after many had believed the credit markets had learned from its past excesses. One panelist noted the CityCenter refinancing at over 8x leveraged through the first liens and 12x through the seconds as one of the “worst deals ever done”, and a strong indication of an over-heated credit market. Another instrument highlighted as being fundamentally unsound are the surplus notes being issued by mono-lines, these are deeply subordinated securities that have little security and function more like preferred stock. They are being marketed to aggressive credit investors reaching for yield, a strategy that most agreed would end badly for those investors. Distressed investors were cautioned against style drift into chasing large-cap HY.

Of particular concern was the observation that over the last several months institutional fund flows into the leveraged loan and HY markets have fallen dramatically while retail flows have increased, particularly retail leveraged loan vehicles. This is believed to be a contra-indicator and confirmation that credit markets are at a top. The Distressed Hedge Fund panelists identified the low quality refinancing being done over the last year as a strong source for potential distressed names over the next 18-24 months. Steve Moyer noted that between 2012 and 2016 there are $650bn dollars in maturities coming due, $150bn of which is Ca1 or below. Many of these issues are trading well below par and are unrefinanceable which will present opportunities for distressed investors. Moreover, Shawn Foley of Avenue Capital cited a JP Morgan report indicating that the majority of CCC rated paper has less than 1 turn of equity beneath it, a proposition he considered unsustainable.

The primary concern among all conference participants for both credit instruments and the economy is the anticipation of a substantial increase in inflation. With PPI up almost 9% and CPI up only 3%, companies are suffering margin compression. Companies will be forced to raise prices which will eventually lead to wage increases to compensate for that higher price level. Commodity prices for cotton, wheat and corn are all near record highs while industrial commodities and oil have also moved higher signaling inflation in the pipeline. In addition, food price rises in non-producer countries in the third world are a major source of global instability and are large factor in the civil unrest in the Middle East. Mid-caps are particularly vulnerable due to a lack of pricing power and international diversification.

In general panelists see a bi-furcated market where larger companies have access to capital and are able to refinance, while mid-caps have not been as successful in obtaining credit or maintaining earnings growth. Due to mid-caps lack international diversification they have not been able to capitalize on dollar weakness and foreign growth. As a result they see the best distressed opportunities in mid-market companies where larger funds can effect rescue financings or distressed M&A. Both Jonathan Lavine of Sankaty and Shawn Foley of Avenue emphasized their companies’ middle market investing and direct lending operations as key areas of activity for them currently and in the future. It was estimated that banks are still sitting on $2 trillion of mostly middle market loans that they have yet to take a write-down on. And while the Fed has pressured financial institutions to deal with their books with respect to residential housing, construction and building products, they have been far more lenient with respect to other sectors. That is particularly the case with commercial real estate, most of which is on the balance sheets of regional banks. When commercial real estate will start restructuring en masse was also a prime topic for discussion. The 2005-2007 vintage LBOs were considered to be the best class of candidates for restructuring opportunities now and in the future.

In addition to panels covering distressed investing, there were several panels focused on the legal aspects of restructuring. The panelists noticed the rise in out-of-court and pre-arranged restructurings (pre-arranged restructurings perform the solicitation while in Chapter 11 while pre-packaged bankruptcies conduct it prior to filing) increased 300% in 2009 over 2008. The trend continued in 2010, albeit at a slower pace. This phenomenon was partially attributed to changes made to the Bankruptcy Code in 2005 that capped exclusivity extensions at 18 months as well as to the increase in 503 (b)9 (administrative expenses) given to trade creditors within 20 days of a filing. These changes are believed to have encouraged consensual restructurings both in and out of court.

The consensus among the panelists was that the majority of successful out-of-court restructurings were those where the capital structure consisted of all bank debt with a limited number of holders. In theses cases, particularly where there was a large concentration amongst a few holders, out-of-court deals were fairly easy to effect. These tend to be middle market companies, although some large LBO’s that were all bank debt and had a concentration of holders also got done. In theses cases the sponsors were able to retain some equity in their portfolio company, as opposed to a court-supervised restructuring where they likely would have been wiped out. Of note was the recent DBSD ruling by the Second Circuit that prohibited “gifting”. “Gifting” is the practice of “gifting” to the equity or junior classes when a class senior to them has recovered less than par. Whether other courts follow their lead remains to be seen, but the practice is likely to be less effective given the precedent for objection. This provides and incentive for Debtors to come to the table earlier to try and preserve equity some value rather than holding out until the bitter end for option value. However, transactions that involve public HY debt with dispersed holders are far more difficult to effectuate outside of Chapter 11. In addition, cases where the debtor needs to use the Bankruptcy Code to reject leases, collective bargaining agreements or pension obligations are not suited for out-of-court restructurings.

Cases involving fraudulent conveyance, equitable subordination and the legal risk in dividend recaps were also debated. The TOUSA case was discussed at length given the recent decision by United States District Court for the Southern District of Florida. In this widely followed case The District Court took the extraordinary move of quashing the Bankruptcy Court’s decision not simply remanding it with instructions, Moreover, Judge Gold issued a 113 page opinion sternly rebuking the Bankruptcy Court and declared the loan to Transeastern holders not to be a fraudulent transfer. There were panelists who were on both sides of the case from the legal and investment community. Some felt that the Bankruptcy Court had initallhy overstepped its bounds, while others believed the District Court had gone too far in giving nearly blanket permission for companies to “lien” up their subsidiaries’ assets and make distributions. The issue of whether the TOUSA subsidiaries received “reasonably equivalent value” was hotly debated and ultimately several of the panelists agreed to disagree on the issue. In addition, the topic of whether the venue influenced the decision was discussed as well as the general consensus that these types of cases are best heard in the Southern District of NY or Delaware. The Tribune case which covered similar issues was discussed briefly as well. These cases along with the Yellowstone Mountain decision are the subject of an upcoming article for the DDIC by the author.

The key take away from a distressed investor’s point of view, is that while there are currently some opportunities in less liquid middle market names, the overall HY and leverage loan markets are experiencing a 2005-2007 type bubble. Those who are patient and have the dry powder will be richly rewarded with opportunities in the upcoming distressed cycle 18-24 months from now.



Distressed Debt 2011 Heats Up: BordersGroup and Ahern

Two quite significant events happened today in the distressed debt world: One widely expected and the other less so. First, as widely expected, Borders Group filed for bankruptcy. The only tradeable security (I've never seen the Term Loan trade) that I can see in the structure as of now is the revolver which is pegged at 96-97. I believe it at least RARELY trades and was quoted in the low 90s in the beginning of January. With that said, given the lumpiness of trade creditors here, I have to think a fairly active trade claims market will develop.

For those interested, you can find the docket here:

And the first day affidavit here:

The real winners here look like Tennenbaum Capital, Stone Tower, and GB Merchant Power -they are providing a $55M senior secured super seniority term loan to Borders at L + 1250 with a 1% floor.

The second big piece of news NOT expected today was Ahern choosing to delay the interest payment on its second lien notes. This one was LESS expected:

Bonds went out at the end of the day 38-42 (flat).

In my opinion, this is one to keep your eyes on. Obviously its unfair to use LTM numbers to value this business. I have to think EBITDA improves here as the general economy / CRE market gets better. In addition, we have a very recent case (Neff, docket here: http://www.kccllc.net/neff) to look at and readily tradeable public comps (RRR, URI, etc). And in my opinion, the most important piece: Don Ahern, CEO controlling 97% company -he obviously does not want to turn over the keys. Why? Well - His father started the company in 1953, Don Ahern's son (Evan) is also an executive of the company and will seemingly take over, Don makes a million dollars a year as the CEO, and the kicker: The related parties transaction page in the 10K is 2 pages long - go for yourself and read them. Incredible stuff.

With that said, does Don Ahern pull a Jerry Moyes and use outside capital to buy up notes at a discount to try to stay involved? He seemingly has a good relationships with his banks - does he ask for more money to formulate a sort of debt for debt swap pushing out maturities and into a PIK structure? It's hard for me to wrap my arms around him just giving it all up. Maybe he runs it into the ground but that's unlikely given the cyclical tailwinds he's probably riding. Using a 7x multiple of $80M of EBITDA less ~$400M of senior debt gets me to a recovery approaching 70 cents on the dollar. I do think there could be downside here, especially if the Term Loan lenders argue that the discount to original equipment cost should be 50 cents on the dollar which with ~$800M of original cost implied $400M of value, essentially wiping out the bonds and creating the company at a multiple of 5x (i.e. massive upside). Valuation fight if it files? Definitely (if I use 6x above, the valuation drops to 35 cents on the dollar...).

This week has been quite active on the distressed front: Seahawk Drilling files to sell its assets to HERO, Tronox, Orleans Homebuilder and Oriental trading exit Chapter 11, Capmarket settlement - despite the primary credit markets being insane, still a lot to keep us busy on the desk.



Emerging Manager Series: Aegis Funds

It gives me great pleasure to bring you a new edition of our emerging manager series. Today, we will be sitting down with the team from the Aegis Funds. I first heard about the Aegis Funds when I did a mutual fund search sorting all "value funds" for the lowest portfolio price to book. The Aegis Value Fund had the lowest price to book of ALL domestic value funds out there. Furthermore, the team at Aegis also manages the Aegis High Yield Fund, one with remarkable performance. One thing I absolutely love about the fund is how different it looks from the standard high yield mutual fund filled with First Data, Clear Channel, MGM, etc. Enjoy the interview!

Thank you for taking the time to do an interview with our readers. Before we start, can you talk about the genesis of Aegis and its value and high yield funds?

When I was at Wharton getting my MBA, I ran across the academic research of Eugene Fama and Kenneth French, which demonstrated that small companies trading at low multiples of price-to-book value were delivering impressive, market-beating historical returns. I was already a Benjamin Graham convert, and was very interested in screening the market to find stocks trading cheaply based on historical fundamentals. My research helped convince me that it would be really interesting and potentially profitable to build a firm focused on exploiting underpriced small company value stocks. After working the summer of 1996 for Donald Smith, a talented deep value institutional investor, I got together with a couple of guys who had recently split off from New York value investing shop Kahn Brothers. We started the Aegis Value Fund in 1998 to invest in a variety of deep value small-cap stocks I had researched and selected. Later, we realized that many of the companies we were looking at for the Aegis Value Fund also had high-yield debt trading at attractive levels. We started the Aegis High Yield Fund at the beginning of 2004 in order to take advantage of these kinds of debt opportunities.

We know many value investors talk about using screens for idea generation on the equity side. Can you talk about your idea generation process for Aegis High Yield fund?

We initially screen for bonds with above market yields across a variety of industries, looking at basic cash flow and leverage ratios for various credits within industry groups to find anomalies. Because screens are not typically well-adapted to pick-up on subjective or complex indicators, the process of delving further into the fundamentals of potential credit candidates is research intensive.

We typically assess items such as management intent and discipline, covenant protection, and collateral valuation and quality. We also have a universe of particular credits we know and understand well given the work we’ve historically done researching the underlying issuers in our equity analysis.

One of Aegis' core beliefs is "Market inefficiencies can be found and exploited through intense fundamental research" - Describe how your research process is different than other buy side shops? Do you find as more and more funds get in the game, the opportunity set of "inefficient opportunities" is getting smaller?

Overall, our approach has generally been focused on smaller issues of companies with material tangible assets. We believe that selective smaller debt issues can often have better collateral and covenant protections as well as higher yields when compared to conventional large high yield issues. We generally look for small company debt that is either secured, or unsecured without any net secured debt outstanding. As a result, we tend to avoid subordinate issues of leveraged financial players. We also avoid technology or health-care issues where success is predicated upon predicting future technological growth or government regulatory reimbursement trends. In our approach, we attempt to model future cash flows over a variety of economic scenarios in order to assess the likelihood of default. We also approach our investments from an asset perspective, and work hard to assess underlying collateral or firm asset values to protect our downside in the case of default. Because our team is always evaluating investments across the entire capital structure, we often uncover possible catalysts for credit improvement, and may have resulting insights that may not be readily apparent to pure credit investors.

With regard to high yield market efficiency, after witnessing the last 3 years it is difficult to conclude that the high yield markets are in a long-term trend towards greater and greater efficiency. More funds have gotten into the game as the market has recovered from the financial crisis, but we must remember that many high yield investment vehicles employing financial leverage were wiped out in 2008. While the markets are clearly more fully valued than in 2009, the rising high yield market valuations are more likely driven by Federal Reserve monetary policy than any move towards greater market efficiency. The current Fed monetary policy itself is likely to be destabilizing over the long run, leading to significant future inefficiencies.

After a year like 2010 of torrid issuance in the high yield space, do you begin to approach the high yield opportunity set more cautiously? Where are you seeing value in the credit space today?

As we look at overall yield spreads rapidly contracting and approaching the lows seen during previous bull market peaks, we are maintaining a very cautious stance when committing new capital to high-yield bonds. While we continue to see one-off opportunities and special situations in the smaller issue space of the debt markets, you do not see the systemic undervaluation that existed from 2009 through the summer of 2010. I noticed recently that only four industries out of 20 in the Credit Suisse High Yield Index have witnessed a 100 basis point widening of yield spread since the end of 2007, Aerospace, Energy, Food & Drug, and Utilities. Energy probably remains our favorite space as a whole, but uncovering investments is certainly getting more difficult. High-yield bonds may continue to deliver reasonable performance for a period of several years if default rates remain low, but we think the tailwind of spread compression is likely finished. In the Aegis High Yield Fund, we are holding higher levels of cash (15% at 12/31/10), keeping our durations short in order to offset both interest rate and longer-term company refinancing risk, and investing in select convertible issues that should do well in a scenario of economic recovery and interest rate pressure.

How much of your analytical time is spent on business fundamentals versus understanding indentures and covenants in assessing the potential risk / reward of a particular situation?

We are primarily business analysts, and spend the majority of our time trying to get the credit call correct. While we think we are skilled at covenant and indenture evaluation, we typically don’t have attorneys skilled in bankruptcy resolution involved in our process of security selection. As such we generally focus our investment attention on stressed credits as opposed to distressed and bankrupt credits, where legal probabilities begin to dominate the process of security selection. When evaluating high yield credits, since most financial covenants for bondholders simply consist of incurrence (and not maintenance) tests, we place a big emphasis on tangible asset based fundamental analysis to establish a margin of investment safety.

Do you use street research and desk analysts in helping you generate ideas or get up to speed on a new situation? Do you have value this type of color?

We have not typically found street research helpful in generating ideas. Although some research can be quite good, generally we have not found the majority of sell-side research adequately devoted to establishing underlying collateral and firm asset value. However, we do follow street issuance of smaller company issue debt that may be disregarded by larger investment firms.

Do you hedge treasury rates in your fund? If so, which vehicles do you use? If not, how do you evaluate and position yourself for changes in the curve?

Although we have the ability to do some hedging through options on equity and index securities, we have not focused the fund on managing our interest rate risk through the use of options, derivatives, or futures contracts. The Aegis High Yield Fund has historically been a long-only, “plain vanilla” type of product. We currently are focused on mitigating the risk of rising interest rates by keeping bond durations short and identifying convertible debt opportunities that can deliver good returns in a rising rate environment.

In your marketing material you note that you "seek out issuers actively engaged in deleveraging/recapitalization of the balance sheet" - Does that still apply today given how low the after tax cost of high yield capital is and how little corporations have spent on capex in the past three years?

There is no doubt that as the public debt markets have made a near full recovery and management attitudes towards leverage are growing more liberal. However, we’ve also seen that the substantial rise in equity prices has allowed companies to use their stock as currency to acquire other assets on an unleveraged basis or refinance existing high coupon debt issues with equity or substantially lower-yielding convertible debt. We certainly take the probabilities of these kinds of corporate actions into account when evaluating bond ideas. Additionally, we see many smaller issuers who do not have the name recognition and broad appeal in the public markets maintaining a conservative attitude towards debt, with many using internally generated free cash flow to deleverage their balance sheets.

Many credit investors struggle with the balance between liquidity and the higher yields of smaller issues in the credit space. How do you balance this tough divide?

This balance is definitely a challenge given our desire to invest in the most inefficient segments of the debt markets. The illiquidity of smaller issues in general is a risk that our firm has decided to accept, despite the price volatility. As a result, we can get superior bond yields in safer credits with superior collateral coverage and covenant protections by investing in smaller, less liquid issues. In order to manage liquidity and redemption risks we tend to maintain a little higher cash balance than many of our peers and invest a portion of the portfolio in more liquid securities. We also try to manage this risk with an open and direct dialogue with clients, so they will understand and be mentally prepared for the near term price volatility that can accompany our strategy. We think the superior long-term excess returns possible are generally worth the volatility.

Long or Short: Rating agencies?

Probably short. Credit ratings are really a non-factor in our investment evaluation process, although we do seek to take advantage of what we perceive to be inherent biases or errors in rating agency analysis by buying or selling securities that are inefficiently priced off of these credit ratings. Downgrades can also drive non-fundamental selling pressure on credits that can sometimes be profitably exploited.

Can you talk about a few of your favorite investment ideas in the credit space?

One area we are heavy in is oil and gas exploration and production (E&P). One of the issues we like are the Black Elk 13.75% Secured Notes Due 12/1/2015. The issuer is a privately owned E&P company with proved, developed reserves in the Gulf of Mexico. We estimate the company’s net debt to trailing EBITDA to be at a very low 1.3 times. At recent oil and gas prices, the company’s net debt is covered by discounted PV-10 cash flows by an estimated 2.7 times. While the bonds, trading today at 102-103, have exposure to Gulf of Mexico drilling catastrophe risk, the private company focuses primarily in the shallow waters of the Gulf. Given that similarly situated larger public Gulf E&P shallow water producers with debt outstanding have single digit yields, we believe we are more than adequately compensated for the market perceived smaller, private company risk.

Another E&P issuer we like is RAAM Global Energy (12.5% Secured Notes due 5/1/15). This company has shallow water production in the Gulf of Mexico, as well as on-land production in Louisiana, Texas, Oklahoma, California, and New Mexico. The $150 million issue is well covered, as the company has only approximately $68 million of net debt, compared to approximately $600 million of primarily mature shallow-water and onshore proven reserves. Net debt to LTM EBITDA is only 0.4 times. The issue currently trades in the 103-104 range.

Thank you so much for sitting down with us.

Thanks again to the wonderful team at Aegis for providing thoughtful answers to our questions. If you are a portfolio manager with assets less than $500M and would like to be profiled in a future edition of the emerging manager series, please shoot me an email: hunter [at] distressed-debt-investing.com



Recent Bankruptcy Rulings and Their Implications for Distressed Investors

A few months ago, I introduced readers to a new author at Distressed Debt Investing, Joshua Nahas, principal of Wolf Capital Advisors. Wolf Capital is a Philadelphia based advisory firm focused on distressed debt, corporate restructuring, corporate finance advisory and capital raising services. Wolf provides advisory services to hedge funds and private equity funds on distressed investing and provides restructuring services to debtors as well as creditor committees. He wrote an incredible piece on investing in trade claims.

In this article, Joshua tackles a number of the more important rulings that have affected secured creditors in the most recent bankruptcy cycle. It is a first in a number of articles you will be seeing over the coming months -while the current 2011 credit market bubble leaves few opportunities to allocate capital to, it doesn't mean we can't sharpen our pencils in anticipation for the next bankruptcy cycle. Enjoy!

Recent Bankruptcy Rulings and Their Implications for Distressed Investors

During this most recent bankruptcy cycle there have been a series of rulings impacting secured creditors in general, and in particular secured creditors seeking to gain control of a debtor through credit bidding. Whether creditors in cases such as Philadelphia Newspapers, Scotia Pacific and DBSD intended to loan-to-own from the outset, or opted to control to take control mid-process in order to maximize recoveries, the rulings that impacted them will shape both the court’s and creditors’ actions in the cycle to come. While the Chrysler case received much broader media attention, its implications are more limited given the unique constituencies and circumstances. That said, distressed investors in secured debt should consider carefully the risks when deploying capital in sectors with significant union concentration where the federal and state governments are going to bring significant influence to bear given the effects a bankruptcy has on working class voters and their communities.

This article is the first in a series of articles examining key legal decisions during last bankruptcy cycle. The purpose is to synthesize the voluminous array of legal analysis and opinions on these rulings and develop essential take aways for distressed investors. While distressed investors rely heavily on the advice and counsel of their FAs and attorneys, in the final analysis the PM must execute his strategy and be accountable for the results. Therefore, it is important to survey the legal landscape and be aware of some of the pitfalls distressed investors face. Particularly for funds that focus on control investments, or who have holdings concentrated in an industry that may result in them being deemed a “strategic investor”. Given the enormous growth in the leveraged loan market, particularly the 2nd lien loan market, many of the rulings in the last bankruptcy cycle were related to secured creditors. The focus of this article is on decisions impacting control distressed investments more commonly referred to as loan-to-own.

In late 2008 and early 2009 as the markets began a precipitous decline, credit, including traditional third party DIP financing from commercial banks, dried up. Many distressed investors were unable to deploy funds to capitalize on the markets’ dislocation. They were getting margin calls on the total return swaps, redemptions from investors and suffering significant mark-to-market losses.

For those players with sufficient dry powder and locked up capital, being the DIP provider gave them the most strategic position in the capital structure, and very often the DIP was the fulcrum security. DIP loans with stringent covenants and milestones calling for a POR or sale within 120 days, enabled the DIP lender’s to gain control of the company.

With traditional DIP lenders on the sidelines, first lien lenders seized the opportunity to roll-up their pre-petition debt into post-petition debt. Such actions are generally frowned upon by the courts because pre-petition debt effectively becomes cross-collateralized with post-petition assets. Moreover, some members of the first lien facility such as CLO’s or long only asset managers are precluded by their charters from originating or participating in DIP loans.

Those creditors who were left behind by the roll-up DIP objected to these loans on the basis that the rules and procedures of bankruptcy did not allow for members of the same class to leap frog them and obtain better recoveries and terms. Nevertheless, with no viable alternative the courts approved many of these loans, although frequently they amended some of the more egregious terms after some trial-and-error. Roll-up DIPs effectively became de facto bridge loans to a credit bid. In situations where the first lien lenders were not the DIP lender, the scenarios were far different and led to some interesting conflicts between debtors and secured creditors, particularly related to secured creditors’ right to credit bid their claims.

Philadelphia Newspapers

In 2006, Philadelphia Newspapers, LLC (debtor), acquired the Philadelphia Inquirer, Philadelphia Daily News, and philly.com for $515 million with a $295 million loan secured by a first priority lien on substantially all of the debtors’ assets. In February 2009, the debtors filed for Chapter 11 after defaulting on their loan agreements. The debtors’ proposed plan called for a sale of substantially all the debtors’ assets in an auction as well as a transfer of their Philadelphia headquarters to the secured lenders. The bid procedures required cash funding and specifically precluded the lenders from credit bidding. (1)

The Stalking Horse bidder in this case was an entity controlled by the local Carpenters Union pension fund and Bruce Toll, a personal friend of the debtor’s CEO. Additionally, until the day before the asset purchase agreement was signed, the Stalking Horse held 50% of the ownership interests in the parent of the debtor corporation. (2) Since the Newspaper properties represent iconic brands in Philadelphia, the debtor also engaged in a public relations campaign branding itself as David “local newspaper” vs. Goliath “Wall Street hedge funds”. This was ironic given that the CEO had mismanaged the leveraged buyout of the company, filed it for bankruptcy and instituted significant head count reductions effecting middle class working people while he earned an $800K annual salary. Nevertheless, the debtor successfully painted the banks as the villain.

The debtor’s POR included a 363 sale at public auction of substantially all the debtor’s assets free and clear of all liens. The sale would not include the debtor’s headquarters which would be transferred to the secured lenders in full satisfaction of their claim. Under the Plan, the purchase would generate approximately $37 million in cash for the Lenders. Additionally, the Philadelphia headquarters which was valued at $29.5 million and would be subject to a two-year rent free lease for the new owners (representing a recovery of about 20%). The Lenders would receive any cash generated by a higher bid at the auction. The plan also established a $750,000 to $1.2 million liquidating trust fund in favor of general unsecured trade creditors and provided for a distribution of 3% ownership to the GUCs if the senior lenders agreed to waive their deficiency claims. (3) Secured lenders objected to the plan because it required all bids on the sale to be in cash, thus if the secured lenders wanted to bid on the assets they would have to pay in cash only to receive the cash back under the plan. Although secured creditors would essentially be paying themselves with a cash bid, the group held firm to the principle of a secured creditors’ right to credit bid.

In October 2009, the bankruptcy court issued an order refusing to bar the lenders from credit bidding. The bankruptcy court reasoned that Section 1129(b)(2)(A) of the Bankruptcy Code (known as the cramdown provision), when read in conjunction with Sections 363(k) and 1111(b), required that a secured lender be able to credit bid in any sale of the debtors’ assets. This provision states that a plan is “fair and equitable” and thus confirmable over the objections of a secured class, provided that the secured class is given the “indubitable equivalent” of its secured interest. Moreover, before a court may “cram down” a plan over the objection of a dissenting creditor class, both the absolute priority rule and the fair and equitable standard must be satisfied. However, the debtor appealed and the district court reversed the bankruptcy court’s decision. The 3rd US Circuit Court of Appeals affirmed the district court’s ruling and addressed the issue of whether secured creditors have a statutory right to credit bid their claims in a 363 sale done in the context of a plan of reorganization. (4)

The 3rd Circuit upheld the POR relying on what is characterized as the “plain meaning” of the Bankruptcy Code Section 1129 (b)(2)(A). The court held the plan could be confirmed as it met the “fair and equitable” requirement of Section 1129 (b)(1) arguing that secured creditors received the “indubitable equivalent” of their claims under the plan. Section 1129(b)(2)(A) lists three alternative paths by which a plan may be “fair and equitable” to secured lenders:
  1. the secured lenders retain their liens to the extent of the allowed claims and receive deferred cash payments equal to the allowed amount of their claim;
  2. the property is sold free and clear of liens and the secured lenders attach their liens to the proceeds of a Section 363(k) sale (which specifically incorporates credit bidding);
  3. OR the secured lenders realize the Indubitable Equivalent of their claims (does not mention credit bidding)(5)

The court reasoned that according to the plain meaning of the statute, the use of the word “or” between the three subsections is a disjunctive clause which allows the debtor to choose one of the three alternatives when selling its assets free and clear of liens. Therefore, if the debtor offers the indubitable equivalent under subsection (iii), the secured lender’s right to credit bid is precluded. The court applied reasoning used by the 5th Circuit In Re Pacific Lumber Co. In the PALCO case the court terminated the debtor’s exclusivity after 1 year and confirmed a plan put forth by a joint bid by a secured creditor and competitor. Additionally, the plan paid the noteholders full cash value of their claims while precluding them from credit bidding on the assets.

The court rejected the secured creditors’ claim that they had the right to credit bid and commented that the credit bid was unnecessary given that noteholders were receiving the full cash value of their claim. The court in Philadelphia Newspapers cited the approach the 5th Circuit took in the PALCO case as one concerned with “fairness to creditors” rather than the mecanics of a cramdown. Moreover, the court emphasized that lenders retained the right to object to the plan at confirmation on the grounds that “the absence of a credit bid did not provide it with the ‘indubitable equivalent’ of its collateral.” (6)

Judge Thomas Ambro of the 3rd Circuit wrote a strong dissenting opinion based on the principle of statutory construction; that specific principles prevail over general ones. (7) The legal reasoning employed in the dissent is beyond the scope of this article, however it provides some great insight and is worth reading.

The PALCO and Philadelphia Newspapers rulings have established that in the context of a plan of reorganization credit bidding is not a right (at least in the 3rd and 5th Circuits). This is significant in that the 3rd Circuit governs Delaware where many large corporate bankruptcies are overseen. However, the issue of the right to credit bid in a 363 sale outside of a plan was not addressed. The court remanded back to the bankruptcy court the issue of whether secured creditors were receiving the Indubitable Equivalent and that the plan met the Fair and Equitable test. That issue was never decided as creditors took matters into their own hands and won the auction with a cash bid of $138.9mm.

What these rulings demonstrate is that secured creditors have lost some strategic ground in being able exercise influence and take possession of the collateral through the right to credit bid. Funds employing a loan-to-own strategy should weigh carefully how these decisions may impact the timing and manner of deployment of capital in a distressed investment. Had the secured creditors been the DIP lenders in these situations, they would have been able to exert far more influence in determining the outcome. It is likely that during the next cycle banks will again be reeling from mark-to-market losses in their trading and CMBS books and will again not be able to deploy DIP capital as was the case in the 2008-2009 cycle. The early part of the cycle will be ripe with opportunities for those funds with dry powder to effectuate control through a third party or roll-up DIP loan.


DBSD, a subsidiary of ICO Global, is a satellite communications company focused on S-Band spectrum that received authorization from the FCC to integrate an ancillary terrestrial component (ATC) into its MSS (Mobile Satellite Service) system allowing them to provide integrated mobile satellite and terrestrial communications services. While the spectrum has enormous value, the large capital expenditures required to launch satellites and fund the cash burn until they are operational, has forced two major players DBSD and Terrestar, majority-owned by Harbinger Management, to seek bankruptcy protection.

The strategic value of these assets has brought into conflict hedge funds such as Harbinger a major player in the space through its company LightSquared, and DISH Network, controlled by satellite mogul Charlie Ergen, who also owns Echo Star Communications. Mr. Ergen has tried to gain control of both DBSD and Terrestar through a loan-own-strategy by investing in the debt of these two companies. The prospect of a strategic buyer using a loan-own-strategy has generated a lot of controversy. In the case of DBSD, it led to a rare decision by Judge Robert E. Gerber of the United States Bankruptcy Court for the Southern District of New York to “designate” or disallow the vote of DISH, a ruling the Second Circuit Court of Appeals upheld.

The facts in the DBSD case are unique in that a strategic buyer (rival corporation) had purchased all of the debtors’ $40mm first-lien secured debt at par in addition to $111mm of $650mm 2nd lien debt not subject to a PSA (Plan Support Agreement). The purchases were made after the debtors had filed an amended plan of reorganization that would have satisfied the first lien debt in full with a new secured PIK note and modified liens.

The creditor’s admitted purpose in buying the debt was to vote against the plan and take control of the debtor. The court found that: “When an entity becomes a creditor late in the game paying 100 cents on the dollar, as here, the inference is compelling that it has done so not to maximize the return on its claim, acquired only a few weeks earlier, but to advance an ‘ulterior motive’ condemned in the case law.” (8)

Under section 1126(e) of the Bankruptcy Code, a court may, on request of a party in interest, “designate” (disqualify) the votes of an entity whose acceptance or rejection of a plan of reorganization is not in good faith. (9) The Bankruptcy Code does not define good faith, thus courts have developed a basis for determining actions that demonstrate a “badge of bad faith”. Such actions include, among other things, attempting to assume control of the debtor, to put the debtor out of business or otherwise gain a competitive advantage, or to destroy the debtor out of pure malice (10)

The court found that “DISH’s acquisition of First Lien Debt was not a purchase to make a profit or increase recoveries under a reorganization plan. Instead DISH made its investment in DBSD as a strategic investor looking ‘to establish control over this strategic asset.’ The Court cited evidence that DISH purchased the debt at par after an amended plan had been filed; and that internal DISH documents and sworn testimony revealed plans to use the purchase of debt to “control the bankruptcy process” and “acquire control” of the debtor, a “potentially strategic asset.” Therefore, Judge Gerber concluded that “DISH’s conduct is indistinguishable in any legally cognizable respect from the conduct that resulted in designation in Allegheny, and DISH’s vote must be designated for the same reasons.” (11)

Under the proposed plan, the first lien debt was to be restructured under an amended facility that extended the maturity of the Senior Debt from one year to four years, provided payment in kind (“PIK”) interest at 12.5 percent, with no cash payments until final maturity. In addition, the first lien creditors would receive liens on all of reorganized DBSD’s operating assets, but not on the securities, which were to be used to secure a working capital line and fund continuing operations. In determining whether the plan should be confirmed, the court analyzed whether the creditor was provided the indubitable equivalent of its claim. The court examined the issue of whether the secured creditors' claim would have the same level of protection as it did prior to confirmation, in other words, did the new note have sufficient collateral cushion. The court ruled that given the assets securing the debt had an enterprise value six times the amount of debt due at maturity, their level of protection was equal. (12)

DISH appealed Judge Gerber’s ruling and upon appeal, the United States District Court for the Southern District of New York affirmed his decision. The District Court held that the Bankruptcy Court’s finding that DISH had acted as a strategic investor seeking control over the debtor was not clearly in error, and rejected the argument by DISH that there was insufficient evidence to establish that they had displayed a lack of good to satisfy section 1126(e) of the Bankruptcy Code. (13) DISH appealed to the 2nd US Circuit Court the designation of its vote and in addition argued that they cannot be forced to accept a reduced collateral package that strips them of their lien on the securities with no substitution. (14) The Second Circuit upheld the District court’s ruling. However, it appears that Mr. Ergen is not going away quietly. It was announced recently that DISH struck a deal with DBSD’s management that would keep all of the debt unimpaired and allow DISH to acquire a controlling interest in the debtor.

While this ruling had unique circumstances given that the creditor was a strategic buyer who purchased its claim at par after a plan had been disclosed, it may provide ammunition to junior creditors seeking to assert leverage in a case where a control distressed hedge fund or private equity fund is seeking to obtain control through the debt. Would the decision be applicable if all the facts were the same except that the creditor in question was a large distressed fund?

At the very least distressed investors looking to acquire controlling interests need to be aware of the risks of being deemed a “strategic investor” It is likely that aggressive junior creditors seeking to avoid a cramdown will now cite this case as a basis for leaving senior creditors unimpaired or unable to vote. Moreover, Philly News and PALCO have left open the question of credit bidding outside of a plan. While not all distressed investors seek control when investing, very often it becomes the only effective means for exercising remedies and maximizing recoveries. In light of these rulings, control distressed investors should be prepared to face some challenges on several fronts in the next cycle. Praemonitus Praemunitus. (Forewarned is Forearmed)


(1) In re Philadelphia Newspapers: Potential Ramifications for Secured Lenders in Debt Restructurings. McDermott Publications: 12.2.2009
(2) Ibid.
(3) Recent Decisions May Stop Secured Creditors from Credit Bidding. Elena González. http://www.abanet.org/litigation/committees/bankruptcy/articles/071310-gonzalez-credit-bidding-secured-creditors.html
(4) Ibid.
(5) Ibid.
(6) Ibid.
(7) Right To Credit Bid Denied In Philadelphia Newspapers, Dow Jones Daily Bankruptcy Review | 10. Wednesday, March 31, 2010. Marshall S. Huebner and Kevin J. Coco.
(8) Disenfranchising Strategic Investors in Chapter 11: “Loan to own” Acquisition Strategy May Result in Vote Designation Jones Day, Recent Developments in Bankruptcy and Restructuring.
(9) SDNY Bankruptcy Court Thwarts Takeover by Claims Purchaser. Cadwalder Restructuring Review April 2010. By Peter Friedman, Leslie W. Chervokas and Samuel S. Cavior.
(10) Ibid.
(11) Ibid.
(12) Ingredients for a Successful Cram Up Reorganization. New York Law Journal, March 1, 2010. Jeffrey Levitan.
(13) Ibid
(13) Ibid



I'm Ringing the Bell

A little less than a year ago, I came up with an interesting paradigm as it relates to risk, or the absence thereof, in the leveraged finance market:

"When investor demand is so strong in the leveraged loan and high yield market that second lien dividend deals are being oversubscribed, it is time to start selling"
Looking through my inbox the last couple of days, a number of truly fascinating email subjects have scrolled across my screen:
  • "Florida East Coast Railway completes PIK toggle dividend" - LCD, 2/9/11
  • "Credit Suisse High Yield Index at All-Time Lowest Yield: - CSFB, 2/9/11
  • "Pricing bloodbath unfolds in February amid repricings, recaps, refis" - LCD, 2/9/11
  • "Datatel sets launch tomorrow of $430M recap loan" (Discusses DataTel's first and second lien dividend recap) - LCD, 2/2/11
  • "Jan '11: Reasons to Be Skeptical About HY Bubble Talk" - Banc of America, 2/1/11
  • "Yankee Candle notes price at 98 to yield 10.8%" (Discusses Yankee Candle's dividend deal to sponsors issued at its holding company) - LCD, 2/4/11
  • "Distressed Buyers Seek Stocks as Debt Bubble Looms, Survey Says" - LCD, 1/26/11
  • Etc / Etc / Etc
Further, you are seeing a fairly ominous trend in the leveraged loan side of the market:

Source: Randy Schwimmer's "On the Left"

Admittedly, these types of environments can feed on themselves for a few months. With that said, you are seeing an ACCELERATION of pricing, terms, and leverage degradation over the past two to three weeks that has left me speechless.

What is driving this? After the treasury curve whipsawed many investors around in the 4th quarter of 2010, everyone started looking for cheap inflation hedges. Bank debt is one such hedge. Consultants starting telling endowments and pensions, advisors starting telling their clients, culminating with this chart:

Dealers will do whatever they can to convince investors to stay bullish. Clients bullish leads to more demand for products which means more investment banking fees (financing, advisory, M&A).

In that, I'm going to ring the bell and say we are deep inside a credit bubble. I do not know when it will burst - could be in a few months or later in the year. And I can't tell you what's going to be the catalyst for the move downward. I remember in late 2006 talking to a strategist at a large bank asking: "Everyone around this table knows things are crazy. What's going to stop it?" His answer: "I think we are in a new paradigm of investing that should lead to years of positive risk adjusted returns." Turns out two Bear Stearns hedge funds and the collapse of the RMBS market was the culprit.

Right now, investors are in no way getting compensated for the risk they are taking in credit. There are much better investments out there in certain parts of the equity market in my opinion (long and short).

A smart man once said "Be fearful when others are greedy and greedy when they are fearful." There is no fear in the credit markets now, investors are stumbling over themselves to get allocations - greed as far as the eye can see. Proceed with caution.



Distressed / Event Driven Funds Take Aim at Smurfit-Stone

A few months ago we highlighted some of the hedge fund ownership of Smurfit-Stone's post re org equity as determined from the HD function on Bloomberg. With that, I am sure all my readers know that Smurfit-Stone has agreed to be acquired by Rock-Tenn. Yesterday, three prominent distressed / event-driven funds sent a letter to SSCC's Board of Directors calling the acquisition price essentially a sham.

In the letter, Third Point, Royal Capital Management, and Monarch Alternative, collectively holding approximately 9% of the company's outstanding shares (60% acquired via the re-org process), express disappointment "at the merger terms [the Board] approved, and to announce [their] intention to vote against the Merger as it stands today."

Their argument is very well laid out and I have included the entire letter below. For full disclosure, I am long SSCC calls as I believe the take out price is far too low. I particularly like the point about the incentives of the acting CEO to sell the business as soon as possible - a point I try to reiterate over and over on this site. Furthermore, the fantastic people over at Footnoted had SSCC as one of their Top 10 acquisition candidates for 2011. They write:

"Just last week, the company filed an 8-K with updated information about the Dec. 31, 2010 resignation of Steven J. Klinger from his roles as President, Chief Operating Officer, and director. The resignation was surprising at first, given the fact that the company had just inked an amended employment agreement with Klinger last summer following its emergence from bankruptcy. But when we dug deeper, we learned that Klinger and the company had previously agreed that within 30 days after Smurfit-Stone got notice that its CEO-at-the-time intended to leave, the company would consider promoting Klinger to the roles of President, CEO, and (potentially) Chairman of the Board. We know that Moore is expected to retire sometime in the next few months, and yet the board did not tap Klinger for the CEO post.

Although Klinger officially resigned, he will be sticking around a bit longer because of an agreement that he and Smurfit-Stone made on New Year's Eve. Per that arrangement, Klinger agreed to work as a consultant from New Year's Day through March 31, 2011 in exchange for the tidy sum of $150,000 per month. He's to perform whatever consulting services the CEO and the Board "reasonably request" him to render; the document doesn't offer any further details. But the agreement appears to be about more than just the money. It also states that when the Consultancy Agreement expires on March 31, 2011, Klinger's unvested options and RSUs will remain outstanding for six more months. If a change in control occurs during that window of time, Klinger's awards will immediately vest.

Given the short-term of the consulting agreement and the specific conditions which benefit Klinger if a change in control occurs by the end of September, we think it's possible that negotiations for a sale are occurring."
If that's not GOLD, I do not know what is...

Enjoy the letter!



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.