Distressed Debt Analysis: Deficiency Claims and Hawker Beechcraft

A deficiency claim in bankruptcy arises when the value of secured lender's collateral does not cover the secured loan principal amount. The difference between the loan value and the collateral value is the deficiency claim against the borrower which becomes part of the unsecured claims pool. With that comes the benefits of voting and recovery of the unsecured claims pool. For example, in previous airlines bankruptcies have seen large deficiency claims arising from under secured lenders that lent against value of airlines that fell in value over the years. In those cases lenders received recoveries from the sale of the loan collateral but also a distribution from the unsecured claims pool recovery (you are actually seeing some of this coming out of the AMR bankruptcy as well - where deficiency claims are being actively traded).

There are significant technical bankruptcy considerations when dealing with a deficiency claim especially in situations where the deficiency claim is large enough to control unsecured vote on a bankruptcy plan of reorganization (and thus 1111(b)(2) comes into play). A debtor may even try to classify a deficiency claim as its own class to push through a plan at the risk of judge striking down the plan as a result of gerrymandering. In fact different circuits have leaned differently in these sorts of cases and I encourage those interested to read up on those decisions (Loop 76, Boston Post Road Ltd., AOV Industries, and most recently in SDNY Quigley). For now, let's stick to the simple reading of deficiency claims and how it applies to bankruptcy analysis of a current distressed situations.

On July 9th, 2012, many distressed investors mouths went agape when it was announced that Superior Aviation Beijing would acquire Hawker Beechcraft for $1.79 billion (!). Hawker is a name that has been discussed in distressed circles for over 2 years now (in fact three write-ups of Hawker have been written up on the DDIC in the past 3 years). I was probably more bullish than most on Hawker's valuation as I generally believe that as world economies grow, the affluent class also grows (but at a faster rater) and hence use and demands for business jets increase. But I didn't think someone would pay a high single digit multiple on 2015/2016E EBITDA. I was very wrong as it turns out multiple parties seemingly want to pay that multiple.

Immediately the bank debt rose from the mid 50s context to the 70s and currently sit in the low 70s for the strip. What is interesting about this case was while the debtor's FA was marketing the assets to a number of parties, a plan and disclosure statement (Docket Items #304 and #305 respectively) was put in place in the event that the company would reorganize as a stand-alone entity. As per the restructuring support agreement ("RSA"), bank debt lenders would receive 81.1% of the new common stock for a $921.6M secured claim as well additional equity ownership as a result of their "Senior Credit Facility Deficiency Claims." 

Some interesting news has come out since the Superior Bid for Hawker: 1) Textron's CEO stated on its Q2 2012 Earnings Call possible interest in either all of Hawker and/or just the defense business, which cannot be sold to Superior [I will note that this wasn't as exciting to me given earlier comments Donnelly said about the "pretty high number" and 2) More importantly, Perella Weinberg noted during last week's hearing that there was at least one bid close to the Superior bid and an auction is to be expected. At first blush there seemed like significant deal risk to the Superior bid clearing hurdles of approval of both US and Chinese governments, union workers, etc but with other possible bids out there, that seems less of a concern.

The company has noted that the currently breakdown of "value split" between secured creditors and unsecured creditors will stick. So the value of secured lenders ultimately receive is heavily reliant on determining the unsecured claims pool in which they will participate. And what makes this case fascinating is that the stalking horse proposal Superior has put in place excludes assumption of Hawker's pension plan which according to the PBGC is underfunded by $751M (see Docket #324 Exhibit C for the clearly defined exclusion of the pension). The IAM says the pensions are underfunded by approximately $500M. In Hawker's most recently 10K, they noted the pension was underfunded by $492.9M (using a discount rate of 5.40% which will obviously come down with the move in the treasury curve). 

Assuming a $1.79B price sticks ($400M for defense to some other party), one must deduct the DIP draw as well as the $50M that is included in the purchase price for Superior's deposits to keep "Hawker jets business open and operational."  The May MOR had Hawker's DIP balance at $230M. The Superior Bid also excludes cash other than customer deposits - cash was $147.9M per the MOR when you exclude the cash collaterized LOCs, though I believe most of this money is indeed customer deposits after reading through some old transcripts. Giving them the benefit of the doubt, I'll say the DIP draw is $250M and cash non-deposits are $50M and admin expenses are $30M (PW is getting 0.65% of the transaction value) for total distributable value of $1.510B ($1.790B - $50M - $250M - $30M + $50M).

We know that bank lenders have a $921.6M secured claim that will get 81.1% of the recovery with the remaining recovery coming from the deficiency claim. To determine the deficiency recovery we need to figure out the size of the GUC. To start, I will use the midpoint of the $500M reflected on the most recent balance sheet of Hawker's 10K and the PBGCs assertion of a $750M under-funding so $625M in pension rejection claims. There is approximately $780M of claims stemming from the deficiency claim of first lien lenders as well as $800M of senior notes (and $300M of senior sub notes that will not participate), along with $60M of unsecured notes related to the EDC facility. Adding in $100M for trade / other gets me to a GUC of $2,365M.

81.1% of $1.51B = $1.224B / $1.7B of bank debt = 72 points. Of the $285M which is going to the unsecured claimants per the Restructuring Agreement (18.9% of $1.51B), 33% is going to the deficiency claim ($780M deficiency / $2.365B of GUC), or $94M. $94M over $1.7B of bank debt is another 5.5 points on the bank debt for a total recovery of 77.5 or up less than 10% from today's levels.

This doesn't seem terrible attractive at these levels (most distressed investors shoot for IRRs 20%+). Upside comes from an auction producing a higher return or a much lower unsecured pool due to an agreement with the pensions being assumed by Superior or the eventual buyer of the company. We will keep readers up to speed on developments in the Hawker case.


Anonymous,  7/24/2012  

Interesting. Thanks for sharing. My first thought was - why aren't the banks arguing for a higher valuation of their collateral, i.e. the secured portion of their claim, in light of this new bid which clearly shows that assets are worth way more than original estimates? Is it because they already agreed to some type of a restructuring agreement with the unsecureds and so they would be unable to change the terms? Or am I missing something completely?

Anonymous,  7/25/2012  

Isn't the allowable claim for the bank lenders $921.6 million, which suggests that their interest in the $1.51 billion is capped at that amount with the balance being split pro rata with unsecured creditors?

So although 81.1% of $1.51B gets you to $1.224B, the claim is for only $921.6 million. That would suggest 921.6 / 1700 = 54 points. Which would leave $588.4M for unsecured claims. 33% of 588.4 million would be $194, which is worth 11 cents to the bank debt for a total recovery of 65 points.


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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.