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.