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.



Request: Tracking Dockets

I had a question for readers: How are you tracking new filings on bankruptcy dockets?

Am I missing a way to get all new filings emailed to me via PACER? Is there a service that does this for funds? Or is everyone just manually checking each docket throughout the day (unlikely)? We have readers across the buy and sell side, but also most prominent law firms in the restructuring practice, so it would be great to get feedback from a variety of readers.

If you have resources, services or ideas I might not be utilizing, would you mind emailing me (hunter [at] distressed-debt-investing [dot] com). It would be greatly appreciated.




Stressed High Yield: CEDC

Every few months, I post a recent idea from the Distressed Debt Investors Club (the "DDIC") to give potential members and guests a feel for some of the ideas being posted to the site. In recent months, ideas ranging from deep value equity to distressed debt ideas have populated the site. For those interested, you can find a list of all the ideas every posted to the site here (scroll navigation at the bottom of the page): List of DDIC Ideas

If my memory serves me right, this is the first idea posted to the blog from the DDIC since we established new compliance policies. We hired a compliance consultant to test our procedures and formulate a robust policy that will encourage idea sharing while at the same providing the correct disclosures and attestations for members. You can view those policies here: DDIC's Compliance Policy.

Every few days, I receive emails from potential members that inquire about the policies and procedures of the site. As stated previously, the DDIC is 100% anonymous. I will be the only one to know members identities and I will never share that information per our privacy policy. Members are free to contact each other via our online messaging system securely and anonymously.

If you, or better yet, your compliance department has questions, please let me know. I have written a number of letters attesting the above facts and can do so for potential members as well. We currently have 215 members versus our stated quota of 250 members and many many more guests (guests have a 50 day delay to the database and no read access to our forums). Theses members come from both the buy and sell side, across a variety of backgrounds. As time progresses, our database of ideas grows larger and I hope you'll consider joining in the near future. To apply as a member, you can go here: DDIC Member Application and Terms

With all that said, enjoy the write up from one of our members on stressed high yield name CEDC.

CEDC - Central European Distribution Corp


I recommend a long position in CEDC’s 9.125% Senior Secured Notes due 2016 at the current price of 60. On a risk adjusted basis, these bonds trade below fair value.

Challenging European spirits markets and several one-off events have challenged investor confidence in recent quarters. The Company’s shares as well as its public debt traded down following the FY2010 results and abridged discussion by management. Lackluster Q1 results followed by the aftermath of Russian licensing challenges and a shift in the excise tax burden announced in 2Q perpetuated the market’s concerns. In 3Q, CEDC’s modest progress in Poland was countered by excise tax in Russia and spirit cost challenges. Class action lawsuits now allege the management team and board misrepresented the severity operating and financial challenges during 2H10 and in the outlook for 2011. Today’s relevant comparables highlight the CEDC’s toxicity in the market.

However, the fundamental investment appeal of CEDC’s credit remains intact. The enterprise continues to demonstrate strong free cash flow potential with favorable positions in value-oriented market share. Given the strong liquidity position, the Company’s credit profile is robust. An eventually normalized Russian market, continued gains in Poland with Biala, and a focus on more profitable sales channels should further bolster CEDC’s creditworthiness as well as the bonds’ pricing following a strong 4Q11 / Q112. Under such a scenario, the bonds can be expected to trade a more appropriate yield of 10-12%, providing very aggressive return potential (40%+ IRR) upon a sale in a 4-6 month timeframe. Alternatively, the attached recovery analysis shows that an investment in today’s bonds would likely be covered, albeit with a thin equity cushion, in the event of a Chapter 11 reorg or out of court restructuring.

Investment Write Up

CEDC is one of the largest producers of Vodka in the world and the largest integrated spirit beverages business in Central and Eastern Europe when measured by volume. The Company produced and distributed 32.7 million nine-liter cases in 2010. Business activities include the production and sale of proprietary brands of spirits, and the exclusive importation of a variety of other branded spirits, wines, and beers in select locales. CEDC operates primarily in Poland, Russia, and Hungary. The Company maintains seven production facilities in Poland and Russia, and employs a workforce of 4,150 people as of year end 2010.

Poland (8.6 million nine-liter cases sold in 2010 / 21 million liters sold in 3Q11):

CEDC is one of the leading producers of vodka in Poland and maintains two production facilities there. The Company maintains top marketshare among traditional channels as well as discounters. Principal brands produced include Bols, Soplica, Absolwent, and Zubrowka. Absolwent and Zubrowka are leading mainstream brands locally, and Zubrowka is exported to many countries including the United States (via Remy Cointreau). The Company also exclusively imports 40 leading brands of spirits, 40 wine brands, and 5 brands of beer. Sales in Poland typically break down into vodka (70%), beer (7%), wine (12%), and other spirits (8%), other (3%). In terms of exports from Poland, the principal brand is Zubrowka into the United Kingdom, France, Japan, and the United States. Additional export possibilities include third party private label production where brands are sold by other labels in countries outside of Poland.

Russia (21.3 million nine-liter cases sold in 2010 / 38 million liters sold in 3Q11):

The Company is the leading integrated spirits company in Russia and maintains 12.4% market share in vodka production. CEDC produces Green Mark, the best-selling vodka in Russia, as well as Parliament and Zhuravli, the two leading sub-premium vodkas in Russia. Other products produced in Russia include Yamskaya, the best-selling economy vodka in Russia, and premixed alcoholic beverages. Primary distribution is through large retail chains and hypermarkets, and CEDC’s relationships with these companies continue to allow penetration in both urban and rural parts of Russia. Operations in Russia also include the Whitehall Group, a recently acquired company that holds the exclusive rights to import premium wines and spirits into Russia and includes several key distribution centers and its own retail network. This acquisition made CEDC one of the leading importers of wine and spirits in Russia. Full financial results including Whitehall are included in 2011 figures in public filings and herein. Sales in Russia break down into vodka (85%) and wine and others including long drinks (15%). In 2010, the Company launched a small operation in the Ukraine to sell its branded vodkas including Green Mark. Market share initiated around 4% at the end of 4Q10, and has grown to 6.7% as of 3Q11.

Hungary (2.8 million nine-liter cases sold in 2010):

CEDC’s business operation in Hungary principally includes the sale of Royal Vodka. This trademark was acquired by the Company in 2006, and the vodka is currently produced in Poland and sold in Hungary where it is the leading seller with 33% market share. Similar to activities in other countries, CEDC maintains importation rights to several other spirit brands as well.

The Company uses Polish zloty, Russian ruble and Hungarian forint as functional currencies in daily operations, but financials are reported in USD. As such, CEDC is exposed to translation movements both on its balance sheet and operating financials. Additionally, CEDC’s Convertible Notes due 2013 and Senior Secured Notes 2016 are denominated in U.S. dollars and euros, and these proceeds have been lent to operations with different functional currencies. The Company has entered into only very limited foreign exchange risk hedging in the past. Financial results and projections in this report for 2011 going forward reflect the full integration of the Whitehall acquisition.

Valuation Waterfall


Recent Company News
Covenant Violation of Bank Facility – The Company violated its bank covenants as of 12/31/2010 and successfully negotiated relief.
  • During 2010, CEDC’s bank credit facility covenants included net leverage and consolidated coverage, tested at the end of every quarter. At 12/31, the Company’s reported net leverage 6.4x (using covenant EBITDA calculation which includes some cash adjustments not described in public filings) due to the decline in EBITDA suffered in FY10, which violated the 5.0x covenant. CEDC also reported an actual coverage ratio of 1.7x, violating a 2.0x covenant. Credit facility lenders waived any breach of the two covenants at the end of FY10 and amended the two covenants to 8.35x and 1.28x for the end of FY10 as well as for the end of 1Q11. In connection with this waiver/amendment, the Company paid a one-time waiver fee of PLN 3.3 million (approximately US$1.15 million) as well as agreed to a reduction of the overdraft facility to PLN 120 million (approximately US$41.6 million) and an increase to the margins on term loan and overdraft facilities to 4.25% and 3.25%, respectively.
  • In April 2011, management reached agreement with select lenders to amend the Bank Facility to eliminate the aforementioned covenants out right. This refinancing successfully avoided an event of default until the Bank Facility as well as cross default provisions for the Company’s other debt which included acceleration implications. Analysis shows that the Company would clearly have violated these covenants at 6/30. Based on the limited information in the Company filings, these credit facilities only extend until 4Q2012.
Completion of Whitehall / Kauffman Acquisition
  • The Company completed the full purchase of the Whitehall Group on February 7, 2011 for $68.5 million in cash and issued common stock worth $23.0 million at the date of close. Additionally, the Company also gained the global intellectual property rights for the Kauffman vodka brand. CEDC owned a minority position in Whitehall prior to this purchase, and that ownership was treated as an equity interest in the Company’s financials. Notably, following the sale, CEDC remained liable for a cash payment to the seller in the amount of the difference between $23 million value of the equity compensation at the sale date and the present value at a specific trigger date. This was settled in March 2011 through a payment of $0.7 million as and stock to the seller.
  • The Whitehall Group is one of the leading importers and distributors of premium wines and spirits in Russia. Kauffman vodka is one of the leading super-premium vodkas in Russia with a strong presence in top end restaurants and hotels and key accounts. The brand is also exported to high-end customers in over 25 countries.
Production Disruption and Licensing Problems in Russia
  • In 11/10, the Company disputed with Russian authorities on the use of old excise stamps to distribute stocked product and the timing of acquisitions of new stamps.
  • This misunderstanding halted production at key factories for two weeks during peak production season (Oct and Nov). The loss of capacity resulted in increased cost of enhanced throughput at other plants and additional transportation expenditures to distribute product.
  • Estimates suggest that this incident cost the Company about $30-35 million through 3Q 2010. The incident also exposed management weakness at the local level.
  • The Company successfully renewed its wholesaler business licenses in Russia, but certain of the Company’s wholesale customers failed to do so. This perpetuated the destocking trend seen earlier in the year, and ultimately cost the Company around $10 million of operating profit in Q2 alone. The complete of the relicensing process is expected to be completed soon as only 25 out of 140 are left to renew their licenses as of 8/4 and the Company is working to sign contacts with new, licensed wholesalers.
Regulatory Shift – Russian Excise Tax
  • During the Company’s 2Q11 earnings call, management announced a change to excise tax regulation in Russia. Effective August 1 (practically September 1 given the Company’s spirit stock), the remaining portion of excise tax that had been paid by spirit producers in the past is now shifted to vodka producers. The cited aim is to provide transparency into the collection of those funds. Notably, even at current higher rates, excise taxes in Russia are only 65% of the rate in Poland.
  • Unfortunately, this increases the Company’s cost of spirit by 35% - which equates to an increase of $11 milion cost of sales for the 4Q11 period.
  • Looking ahead, this increase could be mitigated by a plentiful grain harvest which is expected for 3Q and 4Q in Eastern Europe.
Outside Shareholder Announces Large Equity Stake
  • On 8/29/11, Mark Kaufman reported a 9.6% stake in CEDC. Mr. Kaufman was the chief executive of the Whitehall Group.
  • Kaufman has requested a meeting with the CEDC board to “contribute ideas” and “facilitate additional investment”.
Board of Directors Adopts Stockholder Rights Plan / Poison Pill
  • On 9/6/11, CEDC announced the adoption of a stockholder rights plan / poison pill, likely in response to Mr. Kaufman’s announcement. This is designed to deter hostile takeover efforts as the potential buyer would likely have to negotiate with the board to acquire / control the Company.
  • Functionally, one preferred stock purchase right will be distributed as a dividend on each common share held as of 9/19/11.
Class Action Lawsuits filed regarding 2H10 events
  • During the week of 10/24/11, several class action lawsuits were filed citing CEDC management and board members as defendants.
  • Allegations state that defendants misrepresented and/or failed to disclose the following: (i) that CEDC had double digit declines in its vodka portfolio and its loss of market share in Poland was growing steeper as discounters were taking shares; (ii) that the seriousness in the market share declines required that CEDC take an impairment charge which CEDC did not record on a timely basis; (iii) that the launch of Central European Distribution’s new vodka product, Zubrowka Biala, with significant market spending in the form of rebates, was having a materially adverse effect on gross margin and impacted the channel mix in the market; and (iv) that, based on the foregoing, defendants lacked a reasonable basis for their positive statements about the company, its prospects and growth. It is further alleged that defendants’ false statements caused CEDC’s stock to trade at artificially inflated prices during a period between August 2010 and February 2011.
Industry and Market Overview
Poland – The total sales value of alcoholic beverages in Poland is estimated at $7 to $9 billion in 2010, a 1.9% decrease from 2009 principally due to the global economic recession. Through 3Q11, the Polish vodka market is down 5-6% in volume and spirit prices are up 3-5%. The country is the fourth largest market for the consumption of vodka and in the top 25 markets for total alcohol consumption. CEDC produces vodkas in all four segments (top premium, premium, mainstream, and economy). Poland is the fourth largest beer market in Europe. Sales of beer remained stable in volume in 2010 but still account for 50% of the total sales value of alcoholic beverages in Poland.

Russia - Russia is the largest vodka market in the world with production of approximately 1.05 billion liters in 2010. Vodka represents 95% of all spirit consumption in the country. The market is fragmented with the top five producers containing up to 50% market share. While traditionally there has been a large black market for vodka in Russia, the government recently introduced minimum pricing in 2010 which moved some consumers back into the official market. The long term effects of this change are yet to be determined. Wine and long drinks represent a very small portion of the market, but each has strong growth potential ahead. Overall, regulation of alcohol in Russia is a highly debated and politicized topic today, and both 2011 and 2012 are election years.

Hungary – The spirits market in Hungary is concentrated in brown liquors and bitters. Overall spirit trends in Hungary are decreasing and shifting to import brands from local producers which have traditionally produced lower quality spirits. The a large increase in the amount of imported spirits due to elimination of local duties and increased purchase power by the Hungarian population since the country joined the EU.

Industry and Market Overview

Russia / Whitehall
  • 2010 – 16.9% top line increase reflecting Russian Alcohol Group(RAG) acquisition benefit for the full year, countered by effects of production disruption in Q4 and a heat wave in Q3. Decline in overall market share to 15.3% estimated from 18% in 2009.
  • 2011 Forecast – Topline growth of between 6 and 8%(60%/40% split between existing and new brand growth) as Whitehall completes integration; Restyling of Green Mark and introduction of a new economy brand (Sotka) and a sub premium brand. Diminishing effect of licensing issues into 4Q and an overall a stabilizing market in line with Russian economic recovery (including price increases, as successfully implemented in 1Q11) and a diminishing black market due to minimum pricing. Gross margins will be challenged by the 35% increase in cost of spirit due to excise tax shift initiated in 8/11. Strong export growth into Ukraine and overall improvement in value over volume.
  • 2010 – 14.8% decline reflecting overall market decline, mourning period for the President, increased competition, aggressive marketing spend, and increased raw materials cost. Decline of 3% in marketshare to 22% in 2010. Recovery expected ahead due to enlarged sales force and decline of marketing expenses.
  • 2011 Forecast – Increases in revenue nearing 10% following aggressive marketing yields (Biala) results and larger salesforce, but in a declining overall market; flavor extensions introduced to Zubrowka and Jezowka family in 4Q and others and restyling of Soplica in July; erosion of competitor’s market share; CEDC’s own marketshare remains in the low to mid 20%’s (25% by 4Q) while value to volume continues to improve by the end of the year and exports gain on imports· 2010 – 16.6% decrease reflecting increases in local excise taxes as well as adverse exchange rate changes
  • 2011 – Top line growth of 10% reflecting normalization of pricing and adjustment of costs towards profitability
Key Investment Considerations
  • Integration of Kauffman / Whitehall cash flow - Recent concern over the Company’s inflated leverage may be overblown. In addition to anticipated demand recovery for 4Q11, the Company can expect to realize the financial upside of the Whitehall acquisition and normalized pricing as marketing yields are recognized. Whitehall was financed with cash and stock, and should contribute $30 to $40 million of EBITDA going forward as operations normalize in Russia in 2012.
  • Continued Strong Liquidity Profile / Free Cash Flow Generation – The Company maintains over $110 million of cash on the balance sheet and significant capacity (close to $50 million) under its credit facilities. Looking ahead, the Company should be able to produce an average of $50 to $60 million of free cash flow in each of the next years (25 to 30% EBITDA conversion rate). Accordingly, management is equipped to handle any additional market hiccups and is positioned to de-lever the balance sheet in coming years.
  • Realization of benefit of marketing spend in Poland and Russia – As reflected in historical marketing expenditures, the Company has focused on the promotion of some of its new and up and coming brands over the past 12-18 months. This was done in response to consistent and accelerating losses of market share in 2010, primarily in Poland. One example is Zubrowka Biala (White) launched in Poland in November 2010 where sales volumes came in far above expectations. Here, promotional pricing squeezed margins in Q4, but new customers should add to cash flow levels as promotions burn off and pricing normalizes in 2012.
  • Relicensing in Russia / Destocking reversal – The Company has successfully negotiated new licenses for its operations in Russia, but a few wholesalers are still in the process. The practical implication here is a reduction in inventory levels of wholesalers as they successfully renew their licenses. New wholesalers are brought on board to replace those who fail to renew. Previously, stock had been increased to protect against another production outage for regulatory reasons. Since wholesalers are contractually bound to 4 to 5 weeks of inventory, destocking will reverse naturally. Based on Q3 results, a significant portion of this destocking is still to be realized by the Company in 4Q via both new and old wholesalers.
Investment Concerns
  • Impairment charges in Poland (2010) and Russia (2011) – In 2010, CEDC recognized impairment charges of $131.8 million related to the Absolwent brand in Poland, and an impairment charge in 2009 of $20.3 million related to the Bols brand in Poland. While these charges are non-cash, questions arose regarding the Russian and Hungarian brand valuations and the potential business impact of further similar charges ahead. In 3Q, CEDC incurred goodwill impairment of $547 million ($88 for Poland / $459 for Russia) and brand impairment of $128 million for Polish brands due to cannibalization by Biala.
  • Negotiations with Bank Lenders / Refinancing of Convertible Notes – The Company successfully negotiated with Bank lenders for covenant relief through 4Q12, and the convertible notes are due to mature in 2013. In light of recent financial hiccups, there is a risk that the market may not be receptive to another covenant light facility or a refinance of the Company’s convertible notes at a reasonable cost to borrow. An inability to negotiate could lead to an in or out of court restructuring that would be costly for the CEDC equity holders.
  • Risk of another mismanaged product launch / Poor management decision making. The launch of Zubrowka Biala in Poland led to a sale of three times expected volume in 4Q 2010. Excessive rebates had a negative impact on gross margins and the overall profitability for the Company during that period. These promotions expired in January 2011, but management’s mistakes highlight an apparent inability to control new product launches completely. As such, further gains in market share from marketing pushes could again come at the expense of margins.
  • Higher Spirit Costs / Excise tax shift – A large percentage (40-45%) of the Company’s COGS is raw spirit, the cost of which already increased in 2010 and early 2011 as a result of a poor grain harvest in Eastern Europe. The Company purchases grain at spot prices or on short term contracts. The market, however, believes that the 2011 harvest in the autumn will be much more successful. Management reaffirmed its positive outlook for the late 2011 crop during the 2Q earning call, but management announced a change to excise tax regulation in Russia that suggests a 35% increase in the Company’s cost of spirit, which equates to as much as a $33 million increase in the Company’s cost structure annually.
  • Principal Assets located in Europe / Complications in Chapter 11 or other Restructuring.

Summary Terms



Off Topic: SOPA or H.R. 3261

For nearly two and a half years, I refrained from discussing politics on the blog. If political rants are not your bag, you can close your browser now, and wait until I post something more relevant to the blog's subject matter.

Today, the full Judiciary Committee of the US House of Representatives held a hearing on the “Stop Online Piracy Act” (H.R. 3261) or SOPA for short. You can read the full text of the bill here: “Stop Online Piracy Act” Full Bill. This bill was introduced in October of this year, and if you have not heard about it yet, you will start hearing about it very soon.

Executive Summary: This bill is a testament to the idiocy of our elected Congress.

Is that short enough for you? On the surface, the bill's intended directive is to strengthen copyrights owners rights as related to the protection of their intellectual property, over and above the Digital Millennium Copyright Act which has been the standard for 15 years. The motive behind this is summarized by Judiciary Committee Chairman Lamar Smith commentary on the bill: "Unfortunately, the theft of America’s intellectual property costs the U.S. economy more than $100 billion annually and results in the loss of thousands of American jobs." Much of the Judiciary Committee commentary on the bill speaks to foreign and rogue websites that must be dealt with harshly and punitively.

As always though, the ACTUAL legislation does not match up with the "talking points" espoused by Congress.

In fact, H.R. 3261 completely undermines the safe harbor afforded by the Digital Millennium Copy Right Act which holds that websites will not be liable for their users posting copyrighted materials if they remove said material claiming copyright infringement. Furthermore, and this is a real gem, it FORCES search engines and payment processors (Paypal, Mastercard, etc) to cut all tied with allegedly infringing sites in effect dropping them off the face of the earth. Worse yet, if I, as a content provider, link to an infringing site, I can also be held liable, and my site can be cut off from search engines, advertising networks, etc.

The example I have used to friends in the investment community is that of Scribd. I would wager that 90% of the hedge fund letters or sell side presentations posted on the web are posted via Scribd. I've done it myself, and oftentimes link to hedge fund letters others have put up on Scribd.

Under SOPA, Scribd would no longer be able to exist. And as I've linked to Scribd in the past, I and many other prominent financial bloggers could be held liable and cut off from the DNS directory and search engines.

Google , AOL, eBay, Facebook, LinkedIn, Mozilla, Twitter, Yahoo and Zynga are all vehemently opposed to the legislation. Think about it: If some person uploads to YouTube just one unauthorized piece of copyrighted material, the ENTIRE SITE CAN BE SHUT DOWN. Where are we living? China? Pre-revolution Egypt? This puts an unprecedented level of censorship in the hands of content providers and, if passed, will literally change the way content is consumed on the internet. Definitely for the worse.

For more information, you can read more here: Gizmodo on SOPA as well as the hundreds of articles that will soon be coming out on the issue.


Takeaways from Citi's Distressed Desk Analysts (Average Returns, Cash Balances, MF Global)

Yesterday, Citi kicked off its 2011 North America Credit Conference. As usual, Citi provided a strong offering of management presentations across the credit spectrum as well as many fascinating panel discussions (just to name a few: Global CDS Central Clearing Update, 2012 Implications of Dodd-Frank and Changes to the Banking Regulatory Scheme, a high yield panel, etc). Most relevant to us, Citi's distressed desk analysts presented a variety of actionable ideas to a large audience of distressed debt investors.

Before the analysts discussed their investment ideas, Rohit Bansal, the head distressed trader at Citigroup, kicked off the discussion with a few interesting observations. First, he noted that after to speaking to a number of clients, the average distressed fund was ranging from -5% to 2% in terms of return for 2011. Second, he noted that there was a significant amount of cash waiting on the sidelines, to the range of 25-40%. The "pain trade" as it were is making accounts want to wait until there is more clarity on the macro scene before risking capital. He did note that funds with locked up, long-term capital will be more willing to bid on blocks whereas funds beholden to redemption risks are significantly more cautious.

Next, Marc Heimowitz, Head of Credit Special Situations, touched on an issue that is plaguing the entire investment community: Markets are being driven by macro exogenous risks. In theory, the issues in Greece should not affect the fundamentals of numerous businesses in the United States, but those same issues are dramatically affecting the pricing of underlying securities.

He then moved on to the level of dealer inventory. Here is a chart from Bloomberg:

You can see the precipitous drop since the 1H of this year. What makes this chart even more frightening is when you compare the above to the amount of total corporate debt outstanding which rises year after year after year. This effectively means that the amount of dealer inventory over the amount of corporate debt outstanding is near decade lows.

Personally, this is making execution all the more difficult and dealers (rightly so) are having to make wider markets less they be picked off by aggressive accounts. He closed by nothing they think Lehman's recovery falls into the 31-32 range with a 1 year average life (versus a market near 25.5).

Next, the distressed desk analysts each presented an actionable long / short idea from the variety of their coverages. While, I will not list each of these ideas (contact your Citi sales coverage for the list of ideas), I did want to to touch on one idea in particular, especially given the price action today: MF Global.

We first introduced MF Global's bankruptcy a few weeks ago. Since then, the broker-dealer has been placed into liquidation, a creditor committee for the holding company has been named, and many, many buy side analysts still are doing the hard work to value the recovery to creditors. This price action since the bankruptcy has been anything but stable:

Bonds were up 6 points today, driven by three reasons (in my opinion and listed in reverse chronological order)
  • Creditor Committee counsel, Martin Bienenstock (Dewey & LeBoeuf), said in court: "We think there is potentially quite an estate to be amassed here for the benefit of creditors."
  • Rumors that Appaloosa had been buying bonds in the mid 30s according to unnamed sources
  • Rina Joshi, Citi's distressed desk analyst covering MF, laying out a case that the bonds could be worth between 50 cents to par at Citi's credit conference yesterday.
Rina presented a compelling case and I had the feeling, given the size of the crowd in attendance, the bonds would be up with the pitch. They started the day up 2-3 points and then really rallied into the close as the case proceedings heated up.

Rina first noted, and I think everyone covering the MF situation understands deeply, that there is significant missing info and much of the info analysts are working with is dated (for instance, the last broker-dealer financials we are working with are from 3/31). In essence, the bond (and bank debt) will receive value two ways: 1) inter company receivables and loans 2) equity from subsidiaries, both domestic and abroad.

Most people I speak to have been deconstructing the balance sheet by matching assets and liabilities, and then applying a "friction cost" or haircuts (to both sides in some instances) to come up with equity value that, in theory, should flow up to the intermediate finco and the ultimate holding company. A basis for this is that according to the most recent data we have, MF Global had VERY few Level 3 assets and thus, again in theory, friction costs should not be onerous to the recovery of the estate(s).

Rina demonstrated this with a variety of assumptions of the level of haircuts which restulted in a par recovery for a small levels of haircuts and lower recoveries for larger haircuts for a range of 50-100 cents on the dollar. These levels have to then be discounted depending on your hurdle rate and how long until you expect to receive distributions. Ultimately, and I think this was my biggest takeaway, she noted that the trading level of the bonds imply $2.6B of equity was lost at the organization which she seemed to be aggressive. She did note that if the $500M+ of missing funds were not recovered, this would ultimately affect recoveries on the order of 20-30 cents, but she believes that money is somewhere in the system.

For full disclosure, I have yet to establish a position in the name, despite a nagging feeling that recoveries will be north of 50 cents here. ~$600M doesn't simply just go missing, assets were seemingly liquid, and some people I've spoken to say that a number of the overseas operations are amazing assets that will flow equity to boost holding company recoveries. The needle moves VERY quickly on this one given the leverage (i.e. an assumption of 1% friction costs to 2% friction costs greatly reduces recoveries). I continue to work through the issues and hopefully when the first MOR hits, I'll be able to update my model and share with readers. If you are working on this one, would love to hear your thoughts.



Notes from Invest for Kids Chicago 2011

Here is all the action from Invest for Kids Chicago 2011. Enjoy!

Michael Milken – The Milken Institute
  • Milken noted that he would ot making specific predictions, but a thematic view of how he sees the world
  • Thinks it’s valuable to understand history, and, unfortunately, we never learn from history
  • Churchill said that when a solution to a problem is manageable it is always neglected
  • It is no surprise why Germany is winning in the EU, their unit labor cost are much less than all the PIIGS
  • Germany’s unemployment level is less than 6% vs 21% in Spain
  • Northern Europe has routinely the least amount of problems, and Southern Europe has the most
  • Valuable to look at 1) Perception vs Reality and 2) Capital Markets
  • Perception: What came first the chicken or the egg? The correct answer is egg. Reptiles were laying eggs before chickens existed, and the birds that layed the egg to the first chicken were not chickens.
  • You just need a different perspective on the problem to find the solution. Are we asking the right questions?
  • The U.S. surprisingly has grown it’s oil production more than any other country in the past 3 years. Volatility created alternative production. North Dakota is the 4th largest producing state. ~ 6% of crude output
  • Digital real estate is the important real estate. 6 billion digital phones in the world. Who is going to control the real estate?
  • Brazil: Manaus Brazil use to be the rubber capital of the world. Now it is an electronic manufacturing powerhouse. Foxconn is investing 12 billion in Manuas.
  • The world is moving east. Of the 50 largest GDP cities, 20 will be in Asia. Half of the European cities will drop of the list.
  • Asia has 59% of their population that is 20-34 years old. This is where production and demand will be.
  • The middle class is booming in China, Malasia, Thailand, Indonesia, Phillipines and India -This is where you need to invest.
  • Milken then moved on to his view of the capital markets by beginning with: What is the American Dream?
  • Access to capital is based on ability and not on social status.
  • Profit is a function of Financial Capital * (Human Capital + Social Capital + Real Assets)
  • Give capital to the productive people and employment booms. Figure out how to empower human capital. It is our largest asset as a nation.
  • In the 1920’s the automobile was innovation. 60% of the cost was raw materials and energy. Now innovation is the microchip which is less than 2% materials and energy.
  • It is too difficult to get into the U.S. which means we are losing the top minds. Other countries are getting the students that we will not let in. Australia and Canada, Singapore, and the U.K. are developing the best technology because they are talking more students from Asia.
  • An example of this is Hollywood. All of the 6 largest film studios were started by someone from within 50 miles from Warsaw, Poland. Think if we would not have let them in the country.
  • ½ of all growth is from medical research
  • 70% of health is lifestyle, 30% hereditary
  • The U.S. is the heaviest country on Earth 36.5% obese
  • 1 trillion spent annually on obesity in this country. Think if we could save this just by eating less and changing lifestyle (Apparently we can deep fry butter and dip it in bacon fat. That is why we are fat)
  • Education: U.S. spends 2% of income on Education (33% on housing), Asia spends 15% on education
  • Moving on to Credit: Credit is what counts. Not leverage. Equity is too small a fraction of assets. This has all happened before. All banks in Texas were AAA, but when the energy cycle busts they all defaulted. We need to be extremely careful how we deleverage because it is a multiple factor on the economy.
  • Loans to real estate: Real Estate does not always go up forever it never has. No one knows when interest rates will go up but they know that they will and the cost of homes will go up.
  • 4 companies are rated AAA. However, S&P found away to rate 1600 leveraged securities AAA.
  • Sovereign debt is by far the worst credit. They always default. Adam Smith noted that countries never pay their debts after they reach a certain point of leverage. Greece defaults 1 of every two years before they were in the euro zone.
  • 1974 is important year to study. Interest rates doubled. The market feels like 74. The Nifty Fifty went from a P/E of 66 to 11. Investors lost half their money. Investors flocked to money managers to manage their money. (They could no longer just get by investing int the Nifty Fifty)
Barry Sternlicht (Starwood Capital Group)
Idea: Housing. Homebuilders. Specifically Toll, NVR, Lowes, and HD
  • The world is volatile so you have to look for themes.
  • Residential real estate is where you want to be based on his view of the world.
  • The average amount of house starts for the last decade was 1.1 million per annum. Currently at 300-400k.
  • It could not be a better time to buy a house. Low interest rates. Low housing prices. It is cheaper to buy than rent for the first time.
  • People are doubling up in rentals. Multi-generational families are growing which is causing housing formation to slow. Lots of pent of demand for houses.
  • 3-3.5 million people enter the U.S. every year. This causes the need for 1 million to 1.5 million houses. We are only building 400k.
  • Foreclosures and delinquencies are trending down. Prices are coming up and stabilizing. If you drop out distressed sales from banks they are up. Appraisals are hard to come by in distressed communities.
  • Sees a rebound in housing starts. People will find a way to finance and buy homes given the demand.
  • You could buy levered names but for a turbocharged return but he prefers: Toll, Lennar, DR Horton, and NVR. Specifically, he really likes Toll and NVR
  • Toll: Caters to the haves (vs the have nots). Their world will recover first. 23% gross margins, and over a billion worth of inventory in favorable areas.
  • Also likes Lowes: LOW owns 90% of their real estate. Earnings will be much higher in a bull market. Not only will P/E rise, but E will rise. You cannot be replaced by the internet. You have to have a lumber yard etc. They have lower margins than HD which they can improve. 71% remodeling exposure. Buying back shares. Have already bought back 13%. Trades at a reasonable multiple. TEV/EBITDA of 6.5x. Can buy back 70% of shares in 4 years. (Reminds him of Teledyne)
Richard Perry (Perry Capital):
Ideas: Fannie and Freddie Preferred Securities and RBS Tier 1 Securities.
  • Fannie and Freddie are in conservatorship of the U.S. Government
  • The U.S. has invested $107 billion in Fannie and Freddie
  • The agencies have $34 billion in PFD, $19 raised in '07 and '08
  • Not a litigation situation but it is interesting to look back and see what the government said when the agencies raised those preferreds. It makes you think they may be liable.
  • The PFD trade at 8.5 cents on the dollar. This is an asymmetric risk/reward situation.
  • The government needs to balance their budget. Could increase guaranteed fees slightly (10 BPS), reopen the mortgage market, and spur the economy
  • A 10 BPS raise would result in a $30 billion dollar deficit reduction over 10 years. This helps the government
  • Could also convert to common and monetize the government stake
  • OMB could improve $65 billion to $150 billion by 2021
  • House Financial Services recommended increasing the guaranteed fees
  • Likes the asymmetric risk/reward return
  • Moving on t RBS Tier 1: 10 billion in non cumulative Tier 1 Securities (preferred). EU directed RBS to stop paying dividends through 4/2012. Pari passu “must pay” trade at a 25% to 35% premium to “may pay”. RBS is a restructuring story. Recapped during 2008. Current Tier 1 is 11.3% vs 4% in crisis. 95% loan to deposit, peaked at 154% in 2008. Liquidity portfolio of £170 is 121% of short term wholesale maturities. Sovereign exposure is £772 or 1.6% of Tier 1. Tail risk is supported by the UK gov which owns 82%. £50 bn equity injection by UK was junior to Tier 1. Dividend on common is not payable unless Tier 1 is paid. Large banks perpetual securities trade at 7% yield. Restoring dividends could save money by making the bank more acceptable to investors lowering interest costs. The preferred coupon is deminimus relative to £48 billion in core Tier 1 capital
Tom Russo – Gardner, Russo, and Gardner
Ideas: Large multinational parent companies (Nestle, Pernod Ricard, SAB Miller)
  • Thinking in terms of 10 year investments, not one year
  • If people think the S&P could go down because of Europe (13% of S&P revenue from Europe) they would not like his fund which is 70% in non U.S. companies, 30% in emerging countries
  • Europe is the place to be. Buy businesses that make their revenue away from Europe.
  • Global value investing – “is not for girlie men”L
  • Leading multinational firms benefit from: 1) Capacity to reinvest in high ROICS – corporate wide 2) No dividend burdens (opposed to subsidiaries which are in different companies) 3) Corp culture is knowable (ethics) 4) Corp governance 5) Global talent pool 6) Global best practices – SAB Miller uses their lessons learned in new markets 7) Low valuations are available (Europe is loathed) (revenues are not in Euros) 8) Reduce translation risk. (language barriers)
  • Likes when you can buy the global parent for a lower multiple than subs: Nestle, Unilever, British Tobacco
  • Value Strategy: Looking for 50 cent dollars, capacity to reinvest, capacity to suffer (in other words, a rock-solid balance sheet)
  • Nestle: Investing in countries with growing incomes leads to higher value added product revenues. A large ability to suffer (balance sheet). Stayed in Russia during ruble crisis
  • Pernod Ricard: Went to China. Large capacity to grow and invest. 15% of profits in China. Family controlled. Not thinking short term. India is a large opportunity in the spirit market
  • SAB Miller: Africa: Local brewed beer to bottled beer is a large opportunity in their own back yard. EBITDA margin is down, sales are up. Volatility permits reinvestment. Just bought Fosters.
  • Final thought: Money managers also need the capacity to suffer and stick with conviction in volatile markets.
Leon Cooperman: (Omega)
Ideas: Charming Shops, E*trade, KKR Financial.
  • Leon noted that Omega is normally a bottoms-up show but in this market you must address the macro environment to “set the table”
  • Currently there is record stock and sector correlation
  • Thinks the U.S. will avoid recession but will remain in a slow growth environment
  • "We need 3% growth to dent unemployment, 9% unemployed, 10% more underemployed"
  • All of the global unrest is a result is a result of the economic unrest, wealth disparity, and the uncertainty in government
  • We could see riots in US like Arab Spring and UK.
  • Europe: Expects ECB to execute bailout
  • Obama wants to tax workers and punish savers: 50% of people are on the public dole, do not want a change
  • 2012 will be a test. “If the president is in trouble, the market is in trouble”
  • By the Fed Model, equities are cheap. Yields are higher than interest rates. Average P/E is 15, average treasury yields 6%. Yields today are 3% and P/E is 12x.
  • Equities are cheap. They are the best house in the asset neighborhood.
  • The ten year could jump to 4-6% which would be a big loss in the bond world. Not the place to be. Rather be in credit than bonds. Rather be in stocks than credit
  • Charming Shops: Management needs to get out of Fashion Bug and sell Layne Bryant. No net debt. Lane Bryant alone worth 2x current stock price
  • E*Trade: Great business but invested in mortgage bank. 13.8 billion invested in mortgages. 700 million rolls of every quarter. Earning 80 cents per share. 100 million loan loss provision. 1.5 billion in debt yielding 9%. Improved credit could add 40 cents per share to earnings. A strategic M&A asset in the brokerage
  • KKR Financial: Dividend yield 9% covered 2x by earnings. 28% below book
Mark Lasry (Avenue Capital)
Ideas: GM and Hovnanian
  • GM: Had the largest market cap at one point a number of years ago $12.2 billion. In 2000 revenue surpassed Wal-Mart. Trades at 1x EV/EBITDA. People forget Apple needed a $150mm investment from MSFT. Now it is the largest company. Apple trades at $370 billion, with EBITDA of $35.6 billion. Avenue bought the bonds to create GM at 2x EBITDA now he is pitching it at 1x. US government owns 1/3 of GM, people are trying to find the right time so that they don’t buy in front of the government sale. Now is actually the right time to buy, when everyone knows the government is going to sell. Comps trade at 4-6x (Except Ford trades at 3.1x). So GM could go up 4x. Ford 3.1x, Honda 4.4x, Toyota 5.6x, Hyundai 5.9x.
  • Hovnanian: 7th largest home builder. Housing starts use to be 1.5 million, now 0.3-0.4 million. People will buy homes, the question is a matter of when. Interest rates are low, everyone wants to time it but they cannot. Buy the Senior Unsecured Bonds. Get paid to wait. HOV has a billion dollar NOL. Senior Notes trade at 35, current yield is 20%, (6.5 coupon). They have 350 million in cash on Balance Sheet. 1 billion dollars in land inventory. “Everyone knows this market will turn a question of when” You don’t need the economy to grow faster than 1% for this to work, their view is 1% is the most probable outcome. If Europe defaults this will go down, but you are getting paid to take that risk
Michael Elrad: (GEM Realty)
Idea: Class A malls, specifically Macerich
  • Can you invest with conviction in a volatile market?
  • GEM looks at investing in 3 stages: (Top down, bottom up, and hedging)
  • Their top down analysis led them to Class A malls. Only way to buy Class A malls is through public companies (Simon, Westfield, GGP, Macerich, Taubman). 5 public companies control 80% of the Class A malls
  • 15 years ago retailers were declining. In reality, the fittest retailers survived and now the standing retailers are stronger credits and tenants are more diversified.
  • Today tenants pay more rent and have better credit
  • Sales per square foot have rebounded from the 2008/2009 period
  • NOI has been stable, even though retail sales have been volatile
  • Lost very little occupancy during recession
  • Currently stocks are 20% below their estimate of fair value
  • Macerich is 10% discount to peers. Recommending a 3 year long in Macerich (MAC). Macerich has a 4.9% yield, NOI growth 3% in 2012. 84% of assets are class A. Debt is 45% of EV. 10% discount to big 5. Could be added to S&P. Destaggered board, could be a take out candidate. Approximate a 12% IRR over 3 years. 17% in upside case. To hedge short Class B properties and strip malls (50% hedge ratio)\
  • Do not need to hedge internet risk, because strong internet companies need Class A space to enhance their brand (Apple).
  • This is the future of retailing: "The show room for the online presence"
Barry Rosenstein (Jana Partners)
Idea: McGraw Hill
  • This ideas reminds him of the 1980s. Companies with great assets that fail to create value. 3 reasons: Complacent boards, family CEO asleep at the wheel, Empire building. Or all 3.
  • McGraw Hill: 4 groups: Ratings, Financial Data (CapIQ, Ratings Direct), Educational text Books, Platts
  • Stock manages to under-perform year after year
  • Capital allocation is inefficient
  • Education needs the most capital but has the lowest returns on assets and growth
  • Bloated cost structure because of conglomerate nature
  • Impossible for analysts to value the sum of the parts
  • Management has committed to buy back shares, and cut costs
  • There is more to do: Education is better on it’s own, can take leverage to lower cost of capital (can’t get rated because of S&P currently); Private equity could buy it
  • Platts could trade 5-6x turns higher than conglomerate value
  • They can take out $200 million of costs per year, 6-7 dollars per share in value
  • 15% of market cap buy back over 2 years
  • Break off Platts, Financial. Suitors include Bloomberg, Reuters. Could get a high teen multiple
  • Ratings business is not as bad as it seems. Regulation could make it harder for entry into the business. Real size of claims is smaller than people think. Small number of cases survive.
  • Should trade at $60 per share or 40% upside.
John Keeley Jr.
  • Focus on spin offs, below book value, distressed utilities, S&L conversions, and emerging bankrupt companies
  • Spinoffs drift: not in an index, institutions sell, Individuals sell, no street coverage
  • Case Study: Charles Tandy. Learned from all his spinoffs
  • Average 33 spinoffs per year
  • Idea is ITT: Jan 12 ITT separated into ITT, Xylem, and Exelis. Xylem is fairly valued, Exelis is undervalued. ITT has a good niche, is unlevered, can make bolt-on acquisition, and has room for multiple expansion.
  • S&L conversions: CFFN, ORIT, VPFG, RCKB, TBNK
  • S&Ls have to wait one year to pay dividends, 3 to be acquired
  • TBNK and VPFG are coming up on their 3rd year
  • Dodd-Frank is going to force all of these companies to look for an acquirer. These are the ones they like. Buy the package.
Sam Zell (Equity Group Investments)
  • Globalization has already happened. GDP of Emerging economies equals GDP of developed. The trend is only beginning.
  • Developed world has a Damacles sword hanging above it: Demographics
  • If your population grows, productive investments will follow
  • By 2050. Japan will be one to one. Retired vs. working. Sees no reason to invest in that environment
  • The developed world is “hungry”. People have aspirations. They are confident
  • Brazil: 25% of people in middle class. Going to 65%. Has 180 million people. Self Sufficient in food, energy, and water. Young and upwardly mobile population. Educated workforce. Brazil has pent up demand for products. 7 million houses under demand. Interest rates are high, inflation is high, expected returns are high. There is real demand for capital and that is why rates are high. Need to have a solid partner, cannot go in alone. Brazil reminds Zell of the U.S. in the 1950s. The people are extremely confident in themselves.
  • Trade rule of law for growth in developing countries. He is not ignorant to the risks.
  • Emerging markets are an extraordinary opportunity. Where do they need capital the most. Where are the highest returns?



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.