Last week, Wharton held its 2012 Restructuring Conference. Distressed Debt Investing was in attendance, taking notes. The all day event featured keynote speakers as well as panels covering a range of topics in the distressed landscape. Key note speakers included Rodgin Cohen Chairman of Sullivan & Cromwell, Bryan Marsal of Alvarez and Marsal and Marc Lasry of Avenue Capital. As the title indicates, a great deal of the event’s focus was on where we are relative to the 2008 credit crisis and what the hurdles and opportunities going forward are.
Overall the theme conveyed by the panels was one of cautious optimism. While the US in particular has come a long way in stabilizing the banking system and reducing systemic risk, Europe still has a lot of work to do. Only in recent weeks has the ECB made it clear that it intends to support the overly indebted southern rim countries and that is only because the continents banks, particularly the French, are heavily exposed and would need a massive recapitalization in the event of a default of 1 or more of the so called PIIGS. While the US banks appear to have stabilized the overall operating environment for banks remains constrained.
Regulations such as Dodd-Frank and the Volker Rule have the banks in regulatory which has impacted both market liquidity and bank profitability. Several of the speakers predicted an era of lower shareholder returns and profitability as banks are forced to shed higher risk (return) assets and will be unable to make up the margin completely through cost cutting and efficiency. Moreover, they remain exposed to risks from Europe as well as to further economic slowdown in the US which would increase default rates and stifle loan growth.
Opportunities in Distressed Private Equity
Panelists included executives from Sun Capital, Versa Capital, Alvarez & Marsal, Lazard, SSG and Insight Equity. The panelists all were experienced distressed practitioners with a heavy bent towards operational turnarounds and distressed for control investing. Many of the themes coincided with those of the private equity panel from a week earlier at the iGlobal distressed conference. Eric Mendelson of Lazard echoed a time from my last post which was the merging of PE and hedge fund structures to better capitalize on opportunities in the markets as well as more appropriately match assets and liabilities. These include longer lock-ups, the ability to invest across the capital structure as well as utilizing the division of labor between hedge funds who don’t mind owning businesses, but need the expertise and infrastructure of the PE funds to manage them properly.
Greg Segall of Versa Capital provided insight into the discipline required to be successful in the long term in distressed private equity and noted that many funds from both the distressed debt and traditional buyout arenas have attempted to enter the distressed private equity space and found that they were out of their depth in managing a long term turnarounds in struggling industries and troubled companies. He cautioned mainstream investors that lack both the operational expertise and experience from jumping into distressed because it was the thing to do. He pointed out his own funds discipline in that his fund made no investments in 2009and only 1 in 2010. In 2011 they looked at over 600 deals vs and average of 300 in previous years and invested in 8 of them. Moreover, many of the deals they saw in 2011 were deals that they had seen come around 2 or 3 times where A-Es, equity cures or other deal mechanics provided a temporary respite but had now run their course and banks and owners were more realistic about pricing.
Scott Victor of SSG, a firm that specializes in selling distressed companies, pointed out that banks in 2011 were far more willing to sell troubled loans and take write-offs than they had been in the past. He also noted that strategic buyers have become more comfortable with bidding in 363 sales as well as participating in auctions for distressed businesses, increasing the competition for PE firms.
One example he cited was Big Ten Tires, a Sun Capital portfolio company that went through a restructuring where Sun successfully credit bid the debt it held in the company and retained control through a restructuring. Sun also successfully utilized this technique in Friendly’s recently. while junior creditors generally fare poorly in these instances and issues of fairness and whether equitable subordination are usually raised they rarely succeed. The panelists would argue that the existing sponsor is generally the only one willing to put new money and has the most intimate knowledge of the business.
On the other hand, the presence of a sponsor trying to credit bid its debt likely has a chilling effect on other bidders as they feel they cannot compete against the information advantage and they do not want to devote resources to what they see as likely a foregone conclusion. As a result we are likely to see a continuation of sponsors owning or acquiring the debt of their portfolio companies and to act aggressively to retain control of their investments. Since sponsors must maintain a significant equity stake to generate their required 2-3x return on capital, they have less flexibility than a consortium of debt holders in sharing equity.
In certain instances the sponsor is the only constituent with ability to effect a successful restructuring. The example of Jacuzzi Brands was cited where the existing sponsor Apollo was the only entity who could restructure the company out of court through its position in the 2nd lien facility. This had to do with the fact that there was a change of control in the bank debt (remember Charter) and the current pricing was several hundred basis points below where a new facility could issued. Since Apollo was both the sponsor and the second lien holder it was in the unique position of being able to equitize its 2nd lien position without triggering a change of control.
While Jacuzzi was an example of a novel and creative way to restructure and keep the existing equity alive, the panel also said there are many examples of sponsors and debt constituents (particularly banks and CLOs) that do not behave in a purely rational framework when it comes to their distressed loan books. Agency costs related to amend and extend (or pretend as some refer to it as) are substantial since banks carry most of these loans as held-to-maturity and do not mark them to market. Furthermore, CLOs have no incentive to restructure and hold equity and have been the primary driver behind the A-to-Es done in the last 3 years. However, with many CLOs reaching the end of their reinvestment periods and some only a few years away from their legal finals, it will be harder for them to continue this phenomenon when the next wall begins to hit in the 2015-2017 time period. CLOs cannot extend loans past the legal final maturities of their underlying fund lives.
Several key elements that need to be understood before making an investment in a distressed business were highlighted.
- Cost position: Know the cost position of your target as it is the “ultimate arbiter of corporate conflict”. An investor must know the cost position of the company it is investing in relative to that of its peers in order to gauge their ability to compete.
- Competitive Landscape: Avoid industries where competition is savage, this was likened to sharks fighting with knives. These types of investments rarely work out, particularly when with the added constrain of leverage which leaves very little room for error.
- Historical Performance: How did the company perform in the 08-09 crisis? Several panelists noted that bankers are leaving the 08-09 financials out of their CIMs which is a bad sign. It is important to understand how the company performed under stressful scenarios in order to gauge its ability to withstand another shock and preserve the equity invested.
- Management: Finally it is important to know how management handled the last downturn. Were they a deer caught in the headlights or did they respond aggressively and pro actively? It is important to see how those who are going to be managing your company perform in the face of adversity.
Market Overview from Bryan Marsal
The lunch keynote address was given by Bryan Marsal where he discussed a variety of topics including his role of running Lehman Brothers for the last three and half years. Mr. Marsal shared the difficulties banks are having and are going to continue to have as the result of Dodd-Frank and the confusion that is surrounding it and the Volker Rule in the market place.
Mr. Marsal noted that while banks may be better capitalized than before the crisis, shareholder returns for bank stocks were going to be under intense pressure as the result of the loss of proprietary trading revenue, increasing regulation, higher administrative costs to implement the additional regulation and the movement of many derivatives to exchanges. Moreover, banks are divesting risky assets in an attempt to bolster capital and appease regulators. As a result banks will be left with lower return assets and lower profits, thus painting a bleak outlook for investors in bank stocks. This phenomenon is not unique to the US banks as he noted that European banks are facing a similar outlook with the implementation of Basel III. Regardless, of the speed with which European regulators allow Basel III to be implemented, the long term profit generating abilities of these institutions will fundamentally altered as a result.
Some of the most interesting insights pertained to both the over reaction of regulators as well as a frank assessment of the behavior of many of the financial institutions that lead up to the 2008-09 crisis. He cited an example of how the head of food services at Lehman Brothers was making $1.1MM when he took over as CEO as an example of how bloated and divorced from reality the big financial institutions had become. This behavior has lead to a backlash by regulators and the public who now view our nation’s financial institutions on about the same level as Congress. These swings between greed and fear are unhealthy for the country and seem to result in poorly thought out policies filled with unintended consequences.
Financial Restructuring Panel – Europe
The financial restructuring panel began with an introduction from the legendary Professor Edward Altman of the Stern School of Business at NYU. Professor Altman walked through his latest credit metric which dubbed “The Son of Z-Score” called Z Score PD which uses CDS spreads to estimate the implied probability of default. He applied this model to the Euro zone on an historical and projected basis to show the dramatic increase in the spreads between 09-11, particularly for the southern rim countries and Ireland. The 10-year borrowing cost implied by yields on these countries’ debt he pointed out was unsustainable and he predicted increasing distress in Europe and thought it was too early in game to start putting money to work in Europe.
On the other hand, several of the practitioners on the panel indicated that they have been moving aggressively into Europe to capitalize on the opportunities. While they conceded that it was going to be a long, arduous process, perhaps up to 10 years until it is fully worked out, they felt the returns were quite worth it. In particular when one compares the pricing of European distressed assets versus US distressed assets. It is likely that the assets may turn out to be long-term good investments, while those looking to trade in the securities of those assets may not fair nearly as well. Asian investors, particularly China and India are pouring money into European assets as a long term investment and as a hedge against their investments in the US.
The question of whether the combination Basel III’s capital heightened capital requirements and budget austerity measures will actually do more harm than good. It was asked whether the so-called cure is worse than the disease. Several of the panelists were worried that austerity was short-sighted and that ultimately the only way was to solve the sovereign debt problem was to generate economic growth. While there seems to be a consensus forming around the Greek bailout package, it was noted that Italy is “Too big to save”. An Italian default would overwhelm the northern European countries and the ECB’s resources. This would be met with stiff resistance from Germany who is the most firmly in the austerity camp and whose frugal tax payers and politicians have the most resistance to bailing out what they view as the profligate and less industrious southern European counterparts.
Additional concerns from the perspective of distressed investors in Europe are the lack of any uniform bankruptcy laws across the continent as well as the fact that many European countries are operating and have securities issued in multiple jurisdictions. These factors greatly increase both the cost and complexity of any European restructuring.
Furthermore, European insolvency systems do not have the same methods for providing liquidity particular when it comes to DIP financing. Most insolvencies wind up as liquidations for the benefit of the secured creditors. Moreover, pensions generally receive super-priority status in European insolvencies making it harder to shed liabilities and reorganize. Complicating matters further is the fact that most insolvency regimes in Europe make it illegal to continue to run an insolvent enterprise and subjects the Directors to personal liability. Directors of non-debtor, potentially solvent subsidiaries of companies whose parents file for bankruptcy usually file for bankruptcy as well in order to shield themselves from crippling person liabilities. Another factor making European restructurings more complicated is the limited ability to cram down plans on junior creditors and no ability to cram down the equity class.
The takeaway seemed to be that while there is a tremendous opportunity set in Europe for distressed investors, those wishing to capitalize need to have experience, patience, boots on the ground and an intimate knowledge of the procedures of the various jurisdictions. Those looking to trade in and out of the securities rather than making long term asset plays may find themselves with steep losses, particularly if their capital is not locked up long enough to endure what may be a long, painful turn around.