Profiting from Short Duration Opportunities

When I first started on the buy side, investing in high yield and distressed debt, my boss gave me a book on Michael Milken (Fall From Grace for all those that are interested). In the book, there is a passage, and I am not quoting directly here, on Milken's take on corporate insolvency. Essentially, his take was: It is very hard for a company to file for bankruptcy.

There are really only a few reasons for a company to file for bankruptcy: 1) They run out of cash 2) There is an "unforgiven" covenant default 3) They are trying to eliminate a legacy liability 4) They can't refinance maturing debt and enter in some sort of pre-pack/exchange/etc. In my experience, I have seen very few companies truly run out of cash, have seen very little "pressure" from lenders of covenant defaults (MGM Studios has been in forbearance for nearly a year now), and legacy liability filings get smaller every year.

With that said, a lot of bankruptcies are the result of an over leveraged balance sheet that cannot refinance maturing debt (or cannot conceive of a situation where in the future they WILL be able to refinance said debt). Over levered balance sheets are the result of boom cycles of past, where senior and sub lenders would lever corporations at 80% of inflated LTVs. Gaming historically trades at 8x cash flow, but in 2006 it traded for 14x cash flow, so people levered the entities to 12x. An obvious mismatch of normalized cash flow generation and run-rate leverage.

With that in mind, why do default rates peak and then (generally) decline significantly within 12-18 months of the peak? Because the capital markets open up and corporations can get in front of maturing debt. And with that, there are lots of opportunities to make very high cash on cash returns, if you can use this dynamic to your advantage.

For instance, a few months ago, we posted a DDIC entry on Tembec. At the time, the debt was trading at 86, with two years until maturity. Last week, Tembec announced a refinancing of the debt (http://ca.news.finance.yahoo.com/s/17082010/30/link-f-cnw-tembec-announces-closing-senior-secured-notes-offering-achieves.html). 14 points, on 86 of invested capital in five months...I am sure I don't have to tell you but those are nice returns.

The question the naturally becomes: How do you know which debtors will be able to refinance existing debt versus the debtors that will be blocked from the capital markets? This is where the art comes in but I want to try to give readers a flavor of how I approach these situations?

First, what is the health of the industry? Are there other similar companies doing equity or debt deals? If so, what were the leverage on those deals? Ratings? Spread? Weak covenants? Why covenants? A struggling debtor has a better chance of raising debt capital with tight covenants. It sometimes even gets the deal across the proverbial "goal line." The debtors most assuredly hate this, but nevertheless, the debt is refinanced and they get breathing room.

Second, who holds the debt? Who holds the equity? If there is a large equity holder, there may be a reverse inquiry to also do a debt deal. This gives the equity a long runway to turn its operations around or just wait for the recession to subside. Is the debt held by hedge funds? CLOs? How would you find this out? By developing relationships with your sales coverage and other buy side investors.

Third, the company itself. Is there a story to the EBITDA decline? Did the whole industry decline? Melting ice cube or a cyclical? Is leverage at least reasonable under the new structure? Could sub debt be more easily refinanced into senior debt and if so, will outstanding covenants allow it? A company that is 6x levered with 1 turn of bank leverage and 5 turns of senior leverage may find that doing a 3x and 3x deal respectively may make it easier to raise capital (assuming senior lenders are on board). What is the company's market cap? Could they raise equity? Converts? Remember, bankers are talking to these companies all the time - giving them intel on the various markets - the bankers want them to do a deal for the fees, and the company wants to do a deal to survive (even if management can make more in a bankruptcy via management compensation plans).

Fourth, and really a natural extension to the third point above, what do covenants allow? Will the company be tripped up by tight debt incurrence baskets? Is the current debt outstanding guaranteed by all the subsidiaries? If not, maybe the company could get a guaranteed deal done easier. As noted above, would investors be more "approachable" if the covenants were tighter? If the deal was secured? Etc.

With all this in mind, you still want to focus on the downside. Let's say you are wrong and the company does file: What will be your worst case recovery? If its a zero, stay away - I tend to only do these situations high up in the capital structure. Remember - always focus on the downside.

Is this post a recommendation to get long a lot of short dated paper? No - but I will say that a lot of my time has been spent on these sort of situations - especially given where the curve is and how investors are not getting compensated whatsoever (in terms of total return) for moving further out the curve.

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Distressed Debt Analysis - Fairpoint

Every few months, I post a recent idea from the distressed debt investors club. As a reference to readers, there are about 150 members on the site with over 2000 guests (guests see the ideas on a 50 day delay). In addition, over the past month, over 20 ideas have been submitted to the site. I really could not be happier with the success and encourage all those able to apply. Remember, at 250 members, I will close the application process. With that in mind, here is a recent distressed debt idea on Fairpoint Communications.

Fairpoint Communications: Distressed Debt Analysis

FairPoint ("Company") is a rural telephone company with over 1.2M access line equivalents (ALE). Company is based in Charlotte, NC and operates 33 Local Exchange Carriers (LECs) in 18 states. Company offers telephony, high speed and video services to its customers. Approximately 63% of access lines provide service to residential customers, 29% serve business customers and the rest are wholesale lines.

Prior to acquisition of the Verizon New England lines in March 2008, Company was a public company with a little over 300K lines. FairPoint acquired 1.6M lines from Verizon which were located in Maine, New Hampshire and Vermont. The $2.7B acquisition was funded with $1.8B term loan, $551M of bonds and 54M of Fairpoint shares (pro-forma, Verizon owned 60% of Fairpoint). The agreement with Verizon allowed Fairpoint to use Verizon systems for operating functions (including IT, accounting, HR, billing etc) under a Transition Services Agreement (TSA) while the Company built new systems to accommodate the acquisition. Capgemini was hired to build the new systems under a $160M contract.

The original transition date was September 2008. The new systems were not ready for transition in September and the cut-over date was pushed out to January 2009. Fairpoint started experiencing problems following the January cut-over. Processing times for new orders spiked and billing and collection systems experienced serious issues. Customer service call volumes increased and Company was overwhelmed. Customer frustration translated to increased churn and attracted regulatory attention. As quality of service slipped, the Public Utility Commissions (PUC) (regulate the telecom companies) in Maine, New Hampshire and Vermont imposed penalties on Fairpoint. FairPoint started incurring large incremental expenses as it threw all resources it could to deal with cutover issues. Bad debt due to poor collection, additional expenses to solve the transition issues and penalties caused the Company’s EBITDA margins to drop meaningfully below its peers.

Fairpoint had approximately $2.5bn of pro forma debt outstanding. Financial leverage issues coupled with the problems it incurred in its transition process are the primary reasons Fairpoint found itself in financial distress. The Company exchanged a portion of its bonds for PIK bonds to comply with financial covenants in the bank debt. But increased costs and transition problems made a bankruptcy filing inevitable. The Company filed for Chapter 11 on October 26, 2009 in the Southern District of New York. In the initial plan proposed by the Company, the bank debt holders were to receive 98% of the equity and the bond holders were to receive the remaining 2%. The bond holders started throwing roadblocks into the bankruptcy process, including a request to appoint an examiner. The company filed a new plan on Feb, 08 2010 which has the support of bank debt holders and bond holders. Under the new plan bank debt holders and bond holders received 92% and 8% of the equity respectively ( In addition the bank debt holders will receive excess cash at emergence and bond holders will receive warrants for an additional 12% of the Company at a strike price implied by $2.3B enterprise value). Further, the company renegotiated the union deal to freeze wages until 2013 and reached a deal with the state PUCs on revised capital investments and penalties. On March 11, 2010, the Bankruptcy Court approved the adequacy of the Disclosure Statement and the Company was expected to emerge from bankruptcy in summer of 2010. The plan confirmation required approvals from the PUCs of Maine, New Hampshire, Vermont and other 15 states. Vermont rejected the plan even as the other 17 states approved it. Vermont acknowledged that the Company had made material improvement in its service but believes that the projections were too rosy, inconsistent with Fairpoint’s recent performance and that the Company will overleveraged post-emergence. New Hampshire in its order of approval also noted that while the Company had resolved a number of issues and improved customer satisfaction since the cutover issue, its projections appeared optimistic. Fairpoint does not want to make any changes to the plan at this late stage and is exploring all possible options to address this late surprise. In early August Fairpoint indicated it was going back to Vermont with new information to try and get the board’s approval. The lingering uncertainty and a chance that the whole plan might blow up caused the bank debt to trade down to mid 60s from 80s in early May (it was around 73-74 in late June before the Vermont order came out).

At the current price you are basically creating the company at 4.8x 2009 EBITDA where the average comparable Rural LEC (RLEC) trades for 5.7x EBITDA. Moreover, Company’s EBITDA is loaded with extra costs due to cutover issues and penalties as evidenced by its margin of 26.9% (as opposed to average industry margin of 42.8%). Hence, it trades at half the valuation of the comparables on an access line and revenue multiple basis (see comparables table in the valuation section for details). While the number of RLEC voice lines is declining, Companies have replaced some of the lost voice line revenue with growth in broadband subscriptions and created value through acquisition of other RLECs and cost reduction. Windstream’s recent acquisition of Iowa telecom and CenturyLink’s pending acquisition of Qwest fit this pattern. Fairpoint is unlikely to remain an independent company for long after it emerges from bankruptcy. The current discounted multiple and opportunity to realize higher EBITDA margin presents an opportunity to buy the Fairpoint pre-petition bank debt. Whether the Company emerges with lower than currently proposed debt or a slightly different plan, there is enough margin of safety to realize value once it emerges from bankruptcy. If the plan falls apart and the assets are sold in the bankruptcy, a strategic acquirer should be able to pay more than the value implied by the current price of the bank debt.

Highlights

• Fairpoint’s footprint quality is not very different from other RLECs. From the company's annual reports you can see that the Company’s access line density and the cable telephony competition it faces are comparable to other RLECs. Fairpoint’s larger than average line losses and EBITDA decline has been largely a result of poor management of the systems and the transition problems
• Fairpoint has lower DSL penetration of its access lines compared to the industry. This is mainly because Verizon did not upgrade the New England systems to provide data services. Company has invested in upgrades and started selling data product in region since the middle of last year and has an upside revenue opportunity from increasing data penetration.
• Company’s EBITDA margin is significantly lower than peers due to inefficiencies and additional costs resulting from transition problems. Fairpoint’s EBITDA margin was about 40% pre-cutover but has declined dramatically in the last year indicating that Company has an opportunity to increase its margins meaningfully as it resolves its systems transition issues.
• The plan calls for a recovery of 88 points to the term loan holders (48 pts in new bank debt and the rest in equity) based on 5.4x multiple of 2009 estimated EBITDA of $362. Peers on an average trade at 5.7x EBITDA (see comparables in valuation section). However the pre-petition debt trades around 66 implying a 4.8x multiple of projected 2010 EBITDA. The recovery should be 90 pts based on a normalized EBITDA of $350M and multiple of 5.7x.
• This is a consolidating industry and Fairpoint will likely be acquired by one of the other RLECs. Windstream recently acquired two companies in 2009 and CenturyLink has announced a merger with Qwest (see Appendix for transaction comparables)

Risks

• Company’s recent performance has been worse than industry – access lines declined 12.4% YOY in 1Q10 vs. 6.8% decline for the industry. Anecdotal information from the New England PUCs indicates that the Company has meaningfully improved its service metrics as system issues have been resolved over the past year. This should improve churn metrics and stabilize revenue. Current valuation is already pricing in significantly more deterioration so investors are getting paid to wait for a turnaround.
• Industry has been losing retail lines due to competition from cable and wireless. There were meaningful losses to wireless and cable telephony when the competing products were first introduced to the market and access line loss metric has improved as the competitive landscape has stabilized. Verizon did not market aggressively to business customers in the assets acquired by Fairpoint, which presents an upside revenue opportunity. Other RLECs have been making up for line losses by selling data services. Companies generate a significant amount of free cash flow allowing them to pay large dividends, which has kept the EBTIDA multiple around 6x for a number of years.
• Stock will initially trade without dividends due to restrictions from exit facility (leverage has to be below 2x to pay any dividend and starting leverage should be around 3.0x)
• Plan projections were put together in the summer/fall of 2009. Company’s performance since has been worse than projections. Fairpoint has not updated its projections and actual 2009 performance is below initial projections. It is hard to figure out the precise proforma 2009 EBITDA since one time costs are not all disclosed in the filings. We have revised the projections with an estimate of 2009 EBITDA and modest turn-around expectations going forward. With some EBITDA margin expansion, Company should be able reach about $350M in EBITDA and generate cumulative FCF of $300M+ within three years.
• Vermont’s rejection of the plan creates additional uncertainty in timing and threatens to blow up the deal. It is not exactly clear whether Vermont wants leverage reduced or if they want payment or penalties or something else. But the state realizes (acknowledged clearly in the PUC order) that a Fairpoint stuck in bankruptcy court creates a lot of risk and potentially more problems for telecom customers in its state so Vermont is incentivized to cut a deal.

Valuation

The valuation put forth by the Company’s advisor, Rothschild values the company based on 2009 projected EBITDA and multiple slightly below the trading and transaction multiples for comparable companies. Comparable public companies trade at an average EBITDA multiple of 5.7x. Recent transaction comps support an EBITDA multiple of 6.0x and above

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ACAS and the Distressed Debt Investors Club Update

I wanted to give all our readers a quick update on the Distressed Debt Investors Club. Each week we are getting more and more member and guest application and we could not be any happier with the growth and progress of the site. Throughout the second half of the year I plan on devoting a significant amount of resources to expand the functionality and membership of the site. Currently we have nearly 1500 guests and 140 members. As mentioned in previous posts, the membership for the site closes when we get to 250 members so I encourage those that are interested to apply - you get access to all the previous posted ideas and the Distressed Debt Investors Club forum, a place where I am posting 2 to 3 times a day.

With that, and I try to do this once every few months, I provide you with a recent idea submitted to the site: American Capital (ACAS) [Note - All attachments have not been included in the below write-up. You will just have to join the site to get the 17 page supporting attachment]

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Investment Thesis

ACAS is potentially undervalued relative to the fair value ("FV") of its investment portfolio and its earnings potential as measured by NOI. Meaningfully more leveraged than its peers, ACAS is currently going through a balance sheet restructuring. In the past management was able to leverage the business through issuance of on-balance sheet unsecured obligations-- a capital structure strategy that is unsustainable given the volatility of the underlying assets. The reorganization plan calls for the use of the company's large cash position to pay down debt and exchange unsecured debt for secured issues. More equity has been raised (including appx. 58mm shares 75% of which was sold to Paulson & Co. -- on appx. 280 mm existing) Additionally, in the future, management hopes to sustain leverage through securitization trusts, which has been a successful source of low-cost funds in the past.

There are several catalysts that may realize value in the short term/medium term:

(1) Finalization of the exchange offer/presentation by management with PF-capital structure and business projections.

(2) Continued realization of its current investment portfolio at or greater than FV.

(3) Eventual reinstatement of the dividend on a cash basis.

(4) Mark up of European subsidiary European Capital "ECAS."

Business Model

ACAS is a business development company "BDC," a form of publicly traded private equity vehicle in the United States. Historically, in the United States, there had been a group of publicly traded private equity firms that were registered as business development companies (BDCs) under the Investment Company Act of 1940.

Typically, BDCs are structured similar to real estate investment trusts (REITs) in that the BDC structure reduces or eliminates corporate income tax. In return, REITs are required to distribute 90% of their income, which may be taxable to its investors.

Relative to other BDCs, ACAS's investment portfolio has a higher concentration of equities leading to a more volatile asset base. BDCs generally trade as a multiple of book relative to the FV/Cost of the investment portfolio.

Valuation

Valuation was looked at three different ways:

(1) Current NAV/Share

(a) 5% discount

(b) 15% discount

(c) 35% discount

This indicates potential upside of (-3.4% to +41.2%) or an expected value of (+21%)

(2) Multiple of FYE 2011 NOI:

(a) Base Case: Asset leverage of 45%. Asset Interest Income Yield of 13%. Equity Dividend Yield of 5.5%

(b) Low Case: Asset leverage of 40%. Asset Interest Income Yield of 13%. Equity Dividend Yield of 4.0%

(c) High Case: Asset leverage of 50%. Asset Interest Income Yield of 14%. Equity Dividend Yield of 6.5%

This indicates potential upside of (-32.2% to +90.4%) or an expected value of (+23.3%)

(3) Comparable Basis:

(a) Min, Max, & Median multiples of NAV/share

(a) Min, Max, & Median multiples of FYE 2011 NOI

This indicates potential upside of (-1.3% to +135.5%) or an expected value of (+45.0%)

Taking it all together:

Risks

(1) Even if the reorganization is successful, a worsening of the macroeconomy will negatively effect the fundamental performance of ACAS's investment portfolio companies. Coupled with a further contraction in middle-market transaction multiples, there may be an even more significant decline in the FV of the portfolio.

(2) It is unclear how an inflationary environment will affect the business:

(a) On the one hand, the interest income will rise as rates rise, but,

(b) Inflation may erode fundamental value at the portfolio level.

(3) Any liquidity crisis will make portfolio realizations and further balance sheet restructuring difficult to execute.

(4) It is unclear how dilutive future equity offerings may be (esp. at a discount to book) although it seems that management is very valuation sensitive to this risk.

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Distressed Debt Analysis: Reader's Digest

On February 22nd, Reader's Digest emerged from bankruptcy. For those that are interested, the bankruptcy docket for Reader's Digest can be found here: Reader's Digest bankruptcy docket

Before I get to any analysis, I thought it would be interesting to note to readers that even though Reader's Digest has emerged from bankruptcy, there are still a number of things going on in the bankruptcy court. Some of these filings deal with advisor fees, or tax issues and sometimes things out of left field. For instance, according to docket 764:

Shortly after the occurrence of the Plan Effective Date, Canyon contacted counsel for the Reorganized Debtors regarding its distribution of New Warrants pursuant to the Plan because the Canyon Funds had not received any such distribution. Canyon timely submitted its Class 3 ballots and voted to accept the Plan and has advised the Reorganized Debtors that its funds holding Senior Subordinated Note Claims in the aggregate face amount of approximately $51.3 million intended to submit Class 6 ballots in favor of the Plan, but neither the Reorganized Debtors nor Canyon have evidence of such ballots being submitted prior to the Voting Deadline.

Based on their Class 6 claim amounts, the Canyon Funds are entitled to receive 163,567 New Warrants. Issuing the additional warrants will result in a total of 1,863,394 New Warrants being issued under the Plan (reflecting rights to acquire 6.3% of the New Common Stock issued as of the Effective Date, subject to the terms and conditions of the New Warrant Agreement).

Generally speaking, a lot of these post-confirmation proceedings will not help in our analysis. Sometimes, where there is litigation, there could be updates posted in the bankruptcy court that will update the court on the state of the litigation - but you can follow the litigation generally on its own docket (remember a lot of junior creditors these days are receiving funds from litigation as part of their recovery, so it is important to follow said cases).

Back to RDA. Reader's Digest's equity is traded off quite a few of the distressed desks. For example, JP Morgan was making a market 20.00-20.50 around the close on Friday. In addition to RDA's equity, they have a $525M Senior Secured Note that trades right around par (L+650, 3% Floor). The bond was initially priced at 97, so has done decently well in the high yield market. As of 3/31/2010, the company has $189M of cash on hand, and an a nearly unused $50M revolver. All this results in gross leverage and net leverage of 3.1x and 2.0x respectively.

One thing I like when analyzing a new credit like this is a sufficient amount of disclosure. Their first quarter announcement is incredibly detailed which gives us a good amount of information on their various businesses. In addition, the conference call transcript was quite informative. This tells me management does not have much to hide at this point and is doing its best to communicate with investors. As well they should, as management has warrants to receive 7.5% of the stock.

Management commented on the conference call that given current EBITDA levels ($167M) its low level of capex and cash taxes as well as moderate interest expense, the company "yields high free cash flow." With that said, if EBITDA materially declines, or the company needs to invest substantial amounts of fixed capital to stem revenue declines, the value proposition here might be less attractive.

Reader's Digest operates out of 4 segments: Reader's Digest United States, Reader's Digest International, Lifestyle and Entertainment Direct, and Other. Of the four groups, only Lifestyle and Entertainment Direct showed signs of increasing revenue in 1Q 2010. According to the company's website: "Lifestyle & Entertainment Direct is a global direct marketing business that sells an array of products, including Time Life products under license, primarily through DRTV." Despite revenues being down in 3 out of 4 segments, EBITDA margins expanded in the quarter by approximately 200bps.

For those that do not know what DRTV is - it stands for direct response television - TV advertisers put up a website or a 1-800 number and consumers respond - Reader's Digest Fitness Product has shown significant strength in this market. On the conference call, Mary Berner, the company's CEO stated: "We have an exceptional marketing channel in DRTV, and we intend to more aggressively exploit this robust channel by selling more of our own brands

through it, as well as continuing to work with partner brands."

Currently, RDA's comps trade on the order of 5-6.5x. With that in mind, and using the LTM EBITDA of $167M we can back into what valuation the market is implying for RDA:

Now there are two things we have to do to complete this analysis: 1) How much EBITDA is going to decline? and 2) How much cash flow will be generated in the interim period?

I am going to be conservative and use 3 cases: An annual 15% drop in EBITDA, a 7.5% EBITDA decrease, and a flat EBITDA over the next two years.

So using 5.5x, in 2 years, RDA is worth between 16 and 28 dollars a share. If you are confident that either EBITDA will be flat or that the resulting multiple is more than 5.5x (I am confident of neither), than you would be a buyer of this stock. At a trading level of 20.5, I find RDA as fairly valued here and would neither buy nor sell the stock.

That being said, given the situation above, cash levels at RDA will be near $300M (all else being equal). With debt outstanding of $525M, the debt looks pretty attractive here and probably trades at a discount to peers because of high yield investors typically being fearful of post reorg fixed income instruments.

Reader's Digest presents an interesting distressed debt opportunity and we will keep our reader's updated in the coming months.

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Distressed Debt Analysis - Visteon (VSTNQ)

A few months ago we looked at the distressed debt of Visteon, given the enormous run-up in prices of the underlying securities. Since that post, and as expected, junior securities (equity and bonds) have rallied substantially as Visteon continues to put up strong numbers. In addition, there has been a number of negotiations behind the scene to get a better deal done. Let's take a stab and see if we can see what this thing is worth.

For reference: Here is Visteon's Bankruptcy Docket

Last week, Visteon ("the company") filed a new plan of reorganization with the bankruptcy court (Docket #3011). On the same day, the company filed a motion authorizing the debtors to enter into a plan support agreement, an equity commitment agreement, and a backstop agreement. In this document, the company gives us a little background of what has been going on in the case:

From the outset of these cases, Visteon has made clear that an expeditious exit from bankruptcy with a deleveraged capital structure supported by its OEM customers was its primary goal. To the end, Visteon has worked determinedly with its creditor constituents to develop a consensual plan of reorganization with all voting classes that would address its reorganization goals for the last several months. As a result of these efforts, Visteon has reached a milestone in putting forth a “toggle” plan of reorganization, filed contemporaneously with this Motion, that Visteon believes represents the best path toward a successful conclusion of these cases.

The Plan is comprised of two mutually exclusive sub plans—a rights offering plan (the “Rights Offering Sub Plan”), pursuant to which the holders of Visteon’s prepetition unsecured notes who are eligible to participate in the rights offering would have the opportunity to purchase 95% of the equity in reorganized Visteon in exchange for $1.25 billion in cash raised through a fully backstopped rights offering; and a claims conversion plan (the “Claims Conversion Sub Plan”), which is similar to the plan filed on March 15, 2010 in that the holders of Visteon’s term loan debt would receive approximately 85% of the equity in reorganized Visteon and unsecured note holders would receive approximately 15% of the equity in reorganized Visteon, while other general unsecured creditors would receive a cash payout. The fundamental tenet of the Plan is that if the note holders deliver $1.25 billion in cash plus an exit financing facility to pay the term lenders in full, the Debtors will move forward with the Rights Offering Sub Plan; while if the note holders do not deliver the capital, they will be required to support a “toggle” to the Claims Conversion Sub Plan pursuant to the terms of the Plan Support Agreement and Equity Commitment Agreement, except under very narrow circumstances that the Debtors largely control. In the Debtors’ view, the toggle plan offers the cleanest path to confirmation that would avoid a costly four-sided cram down fight and would localize and simplify a valuation fight to one between old equity, on the one hand, and everyone else, on the other. The “toggle” plan construct allows note holders to truly put their money where their mouth is, while minimizing the Debtors’ risk of being left at the confirmation altar without a confirmable plan if the note holders do not live up to their promise to deliver capital. The Plan also avoids what would be costly and protracted cram down litigation with the Debtors’ note holders and resolves disputes over valuation among all parties other than “out of the money” equity holders who will dispute any valuation that does not provide them with a recovery.

The Plan is fully supported by note holders holding more than two-thirds in amount of Visteon’s prepetition unsecured notes and the Debtors continue to work towards obtaining the support of the official committee of unsecured creditors, a proxy for the general unsecured creditor class. While the term lenders have not yet indicated a willingness to support the Plan, Visteon notes that the term lenders would receive the same, or an equivalent recovery, to which they would have recovered under the March 15, 2010 plan. Specifically, the term lenders would be paid in full, in cash, including accrued prepetition and postpetition interest, and therefore would be unimpaired, and without voting rights, under the Rights Offering Sub Plan and would receive virtually the same treatment under the Claims Conversion Sub Plan as was contemplated by the Debtors’ March 15, 2010 plan, for which they previously provided their support. Thus, the Debtors believe that the term lenders ultimately will support the Plan. Lastly, while the Debtors expect equity holders to oppose the Plan, such holders are deemed to reject the Plan and will not be entitled to vote—making their support irrelevant to Plan confirmation.

Now that is a mouthful I know. Let's break it down:

• 2 possible paths: 1) Rights offering funded by bondholders after which they will get 95% of the equity and will pay down the term loan from the funds raised 2) If rights offering fails, old plan is the go where term lenders own the vast majority of the company 3) Equity gets nothing

What I found most interesting about this plan was point #3 above. Earlier in the month, the U.S. Trustee recommended the appointment of an examiner after the ad hoc equity committee requested one. From a recent court filing:

On February 26, 2010, the Debtors released 2009 year-end financial results that dramatically changed the course of these cases. The Debtors’ enormously improved financial performance, as well as the market’s reflection of the bright prospects for the automotive sector and the economy as a whole, have rendered the Debtors’ intended path for these cases illegal and improvident. Indeed, prior to the release of the 2009 financial results, the Debtors filed a plan that provided no recovery for unsecured debt, much less equity. Now, that same unsecured debt is trading above par plus accrued interest. To pretend that this is a typical case where the Debtor has worked over the course of a year towards an inevitable plan that extinguishes equity is disingenuous. Yet, despite these different circumstances, the Debtors remain on approximately the same path as before and continue to stand behind a plan that rests on erroneous valuations and projections simply unsupported and refuted by the currently improving financial landscape.

Source: http://www.kccllc.net/documents/0911786/0911786100507000000000016.pdf

In addition, equity holders have filed a motion to terminate the debtor's exclusivity and to solicit votes their their own Chapter 11 plan. What is equity arguing specifically? Undervaluation. As a reference, most equity committee's argue for undervaluation, but in Visteon's case, the argument is fairly compelling: Why? Visteon has a massive amount of value in its JV and cash on its balance sheet which current plans are undervaluing (2.5x net income? HA).

The equity committee is proposing a new plan where the term loan lenders would be partially reinstated (paid down with an equity rights offering), bond holders would receive a new security, and equity would be reinstated. The downside of this plan: The company would be emerging with a significant amount of debt which in a judge's eyes would make it less favorable to a competing plan.

For reference, Visteon's EBITDA was $161M in 1Q 2010 vs $22M in 1Q 2009. Strong. Cash at year end is approximately $1 billion dollars. The trading level of securities:

• Term Loan: 106-108
• Visteon 8.25% of 2010: 111/112
• Visteon 7% of 2014: 112/113
• Visteon 12.25% of 106: 115/117
• Equity: $1.70 resulting in a market cap of $221M.

Let's figure out how much this puppy is worth:

• Halla: Visteon has a 70% position of a Korean auto supplier. The company today has a $1.4B USD market cap...$980M of value.
• Other non consolidated JVs: Mostly Yanfeng: "The major products are automotive interior and exterior trim products. such as seat assembly. instrument panel assembly,door trim panel assembly, steering wheel assembly, sun visor assembly, color bumper, B pillar and C D pillar etc. " Visteon owns 50%. Assume $80M of attributable net income (meaning the 50% that the company gets) at a 10x multiple...$800M
• Cash - $964M ... Assume 50% is retained...Approximately $500M of value

So before even looking at Visteon's underlying operations we have approximately $2.3B of value.

Because Halla is consolidated in Visteon's results, we need to back out their cash flow and then apply a multiple to stand-alone Visteon's EBITDA. Halla is doing right under $140M of EBITDA, so run-rate stand-alone Visteon is probably close to $300M on a VERY conservative case. At a 5x multiple, we get another $1.5B of value. Net, net...Total value is $3.8B.

For debt claims, I am using $3.2B. Therefore the excess value to equity is $600M against 130M shares outstanding leads to a share price between $4 and $5. This valuation also does not give them any credit for NOLs. But we like to be conservative here at Distressed Debt Investing.

So we think equity has value here - the question is...will they get any of it? It really depends on how the judge plays his hand. And I will save portfolio positioning for the next post. We will discuss the implications of the varying guarantees of the bonds (the 12.25% have certain guarantees that other notes do not have), the possibility of equity get a nuisance value claim and how that affects portfolio positioning. Finally, we will talk about par + accrued and possibly make-wholes to determine our downside on the bonds.

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Distressed Debt Concessions and Settlements

A pivotal aspect of distressed debt investing is the negotiations among opposing (read: warring) creditor factions. Senior creditors may want one thing, but subordinated bond holders want another. Sometimes people throw the "cram down" rule as a gauntlet in negotiations when in fact they may not even have the necessary stipulations as required by 1129 of the bankruptcy code to cram down a dissenting creditor class. Many of these negotiations are worked out behind the scenes - when evaluating an investment in a bankrupt creditor, it is prudent to play out all likely scenarios to see where ultimate recovery will come out.

Some of the more interesting cases are when a single creditor class has differing views about how a settlement or concession may play out. This is important, because under the code, from the US Courts website:

Under section 1126(c) of the Bankruptcy Code, an entire class of claims is deemed to accept a plan if the plan is accepted by creditors that hold at least two-thirds in amount and more than one-half in number of the allowed claims in the class.

This exact situation is playing out in Tribune's bankruptcy proceedings. Some background: Last week, Tribune announced it had come to an agreement between Centerbridge, J.P. Morgan and certain other senior secured lenders that would enable the company to file a plan and possibly emerge from bankruptcy. Under the settlement, Centerbridge and other pre-LBO senior debt holders would receive 7.4% of the cash, debt, and equity of the reorganized debtor's distributable enterprise value. The catalyst for this settlement was Centerbridge and other creditor's assertion that the LBO was effectively a fraudulent conveyance. On the news, the bank debt traded up a couple of points. To note, in the marketplace, a settlement was widely expected and in my opinion the bank debt traded up due to the 7.4% distribution being slightly lower than the 10% thrown in the market running up to the announcement.

This is where things get interesting. I have embedded the full response below.

Tribune AdHoc Lender Response

The ad-hoc lenders, which I listed in a previous post, and include some pretty big names in distressed debt are saying: "Nope. This won't do." And because they represent 42% of the bank debt, people should listen. From reading the document, it is readily apparent their main issue is that there are far too many releases being granted in exchange for nothing. Further, the bank group, via their post-re org equity interests, would fully indemnify Sam Zell, Tribune's directors and officers, the bank debt arrangers, etc. Everyone wins except the bank debt holders.

The ad-hoc lenders are asking the court to end exclusivity so that they themselves may file their own plan of reorganization (this will be their third attempt). Their plan looks to either shut down Centerbridge's claims of fraudulent conveyance by filing a "subsidiary only plan" (see above document for explanation). They also consider setting up a litigation trust among other actions which may allow the company to exit bankruptcy quicker as the company could emerge from bankruptcy and the litigation trust could deal with causes of action relating to the LBO.

After the close today, Tribune filed its own plan. We will find out soon enough where the direction of the case is headed because also filed tonight on the docket is the Amended Agenda of Matters Scheduled for Hearing on April 13th, 2010 at 10:00AM (tomorrow). Item 14: Debtors' Motion for an Order Pursuant to 11 U.S.C. 1121 (d) Further Extending Debtors' Exclusivity Period ... Responses Received: The above docket I have embedded.

We do not know which way the judge will rule in this one. If the ad-hoc group holds itself together (I am sure J.P. Morgan will be working the lines to work people over to their side), I do not see how the current plan gets confirmed. I have to think either settlement gets renegotiated. We will see though. Will be an interesting day in court.

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Six Flags and Incremental Recoveries to Junior Bondholders

Approximately a year ago, we analyzed the debt of Six Flags. Our recommendation was to buy the bank debt at 72. Currently that debt trades at 101. In round numbers, about a 40% IRR. On an absolute basis a strong number, relative to where we could have played in the capital structure: Not so much...

Currently, the senior opco notes at Six Flags trades at 113-115 and the holdco notes trade in the 31-33 context. Those are doubles and triples from when we wrote the post a year ago. Hindsight is 20/20 of course - I sacrificed upside potential, for downside protection. A better question to ask: Has Six Flags fundamentally changed so much in one year that the intrinsic value is really that much higher?

Some background: Six Flags has gone through a number of plan iterations. First the bank debt holders were going to get the majority of the equity. Then the opco holders were going to get the majority of the equity. And finally the hold-co debt, as the plan is currently filed, will get a majority of the equity. Initially they said they were going to force current management out, but when the plan emerged and it was revealed management was going to get 15% of NewCo (yes, you read that right), it was plain to see that incentives were aligned for the holdco plan to be taken up and adopted by management.

A Dow Jones Daily Bankruptcy Review article points out that Avenue Capital (the driving bondholder representing the opco notes) will lead a challenge of the Chapter 11 confirmation. They will argue that the plan that gives the majority of the equity to holdco noteholders will leave the new Six Flags with a burdensome load of debt and will challenge the feasibility of the plan. Therefore nothing is decided at this point, but we fashion a guess that the hold-co plan, which now pays out senior lenders in cash (vs. reinstating) will be approved.

Nonetheless, back to the original question: Has Six Flags fundamentally changed so much in one year that the intrinsic value is really that much higher?

For one, multiples have moved higher in the industry. At the time, Cedar Fair traded at 6.5x; Now with the proposed Apollo buyout, it trades for 7.5x. Using 7.5x versus the projected 2011 EBITDA of 260M (I initially forecast slightly higher), derives an EV of $1.95B more than enough to pay off both senior lenders and opco bond holders. So I was too low on my multiple.

Secondly, credit markets are WIDE open right now. On both the bank and bond side, most deals (except for the hold-co dividend deals which are reappearing) are well oversubscribed and dealers are flexing terms. While the hold co note holders didn't technically NEED to appease the bank debt holders by paying them in cash versus reinstating their low coupon paper, they did it to ensure their plan gets accepted by one of the larger creditors groups in the case. Six Flags did a term loan a month or so ago that was to finance the opco plan- that deal was oversubscribed. That being said it wasn't a stretch to assume you could layer on more senior secured debt (second lien) to get more cash in the door to help pay pre-petition claims. Would I have guessed this the case a year ago? Frankly, no.

Finally, and something that very few people are talking about right now, but from what I have heard, hedge funds are no longer in "deal with redemptions" mode. As returns continued to be impressive throughout 2009, more redemption requests were withdrawn, and funds that were sitting with idle cash on the side, ready to meet redemptions, needed to put that money to work to at least keep up with this rocketship of a market. That being said, funds are more able and willing to backstop rights offerings or provide fresh capital to reorganized debtors without having to deal with their LPs on their backs. A year ago, no one fund, or even groups of funds, would be able to step up to the plate and execute a $600 or $700M rights offering.

In my opinion, higher valuation, easier access to exit/debt capital, and more parties willing to fight over providing fresh capital to debtors via right-offerings has been the real driver of returns in distressed land over the past 12-18 months. Yes, some companies have seen dramatic improvements in operating performance, but to me the real driver to this rally (which has disproportionately helped junior creditors and equity holders) has been the multiple expansion (valuation in the bankruptcy court still relies on comp analysis) and the capital markets being awash with liquidity.

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Distressed Debt Equity Example - Visteon (VSTNQ)

In the past, I have pointed readers to the concept of understanding incentives in a distressed debt analysis when it comes to evaluating disclosure statement, plans of reorganization, and financial projections. In my opinion, management teams will side with the creditor class in which they will benefit most financially. I do not mean to admonish management teams for this action - they are acting in their own best self-interest (read: incentives) which, as I have reiterated in the past, is one of the keys to understanding how a certain bankruptcy case will unfold.

Below, you can see a 1 year chart of Visteon's equity (VSTNQ):

And also below, you can see a 1 year chart of Visteon's 8.25% notes due 2010:

I doubt I need to point out to the reader that if you had invested in either of these securities at the beginning of 2010, you would have a proverbial "home run."

So what happened? How can a bond nearly quadruple in a matter of two months, or for that matter an equity increase exponentially in a few trading days.

On December 17th, 2009, Visteon filed its disclosure statement in the Delaware bankruptcy court. Here are is the salient passages from the document:

"Based on the valuation analysis prepared by the Debtors and their advisors (the "Valuation Analysis") and the Term Loan Lenders' secured position in the debtors' capital and corporate structure, the Plan contemplates that the Term Loan Lenders wil receive a 100% recovery on their Claims, which equates to an approximate 96.2% implied equity ownership interest in Reorganized Visteon and that the PBGC wil receive a 12% recovery on its Claims, which equates to an approximate 3.8% implied equity ownership interest in Reorganized Visteon."

96.2% + 3.8% = 100% = Nothing left for anyone else, i.e. the aforementioned bond holder and equity holders. But this all based on this Valuation Analysis. Let's take at what I view as important quotes / line items:

The Valuation Analysis is dated as of December 15, 2009 and is based on data and information as of that date.

Meaning they don't have full year numbers...(emphasis added below)

In preparing the Valuation Analysis, Rothschild has, among other thngs: (1) reviewed certain recent available financial results of the debtors; (2) reviewed certain internal financial and operating data of the debtors, including the business projections prepared and provided by the Debtors' management to Rothschild on December 15, 2009 relating to their businesses and their prospects; (3) discussed with certain senior executives the current operations and prospects of the debtors; (4) reviewed certain operating and financial forecasts prepared by the debtors, including the Financial Projections; (5) discussed with certain senior executives of the debtors key assumptions related to the Financial Projections; (6) prepared discounted cash flow analyses based on the Financial Projections, utilizing varous discount rates; (7) considered the market value of certain publicly-traded companies in businesses reasonably comparable to the operating business of the debtors; (8) considered the value assigned to certain precedent change-in-control transactions for businesses similar to the debtors; (9) conducted such other analyses as Rothschild deemed necessary and/or appropriate under the circumstances; and (10) considered a range of potential risk factors.

Rothschild assumed, without independent verification, the accuracy, completeness, and fairness of all of the financial and other information available to it from public sources or as provided to Rothschild by the Debtors or their representatives. Rothschild also assumed that the Financial Projections have been reasonably prepared on a basis reflecting the debtors' best estimates and good faith judgment as to future operating and financial performance. To the extent the valuation is dependent upon the Reorganized debtors' achievement of the Financial Projections, the Valuation Analysis must be considered speculative...

You will notice the sections I have bolded all have one thing in common: Management was driving the ship...

Then this:

Rothschild estimates the Reorganized debtors' implied reorganized common equity value to be $1.505 bilion based on the midpoint of the DEV range. The common equity value is subject to dilution as a result of the implementation of the Management and Director Equity Incentive Plans.

Management and Director Equity Incentive Plans...Let's take a quick look and see what that means...

Certain of the Debtors' management and directors wil be entitled to participate in the

Management and Director Equity Incentive Program, which shall be set forth in the Plan Supplement. The Management and Director Equity Incentive Program shall have an aggregate share reserve of up to 10% of New Visteon Common Stock issued in accordance with the Plan, on a fully diluted basis. The Management and Director Equity Incentive Program shall be deemed approved and authorized without further action by the New Board.

10% is a big slug of ~$1.5B of equity value. How much equity did management own before the bankruptcy? From their Visteon's recently filed 10K:

Hopefully you see the little asterisk represents less than 1%. So in aggregate management owned less than 1% and now they are getting 10% of the company?

Wait - hold on - Management and the board are getting 10%, but the PBGC is only getting 3.8% of the new company. What kind of stake did the pension have in the game? Again from Visteon's 10K:

Chapter 11 Plan of Reorganization

The Plan, as filed with the Court on December 17, 2009, contemplates that the Debtors may pursue the termination of certain of the Debtors' pension plans. The Plan provides for the Pension Benefit Guaranty Corporation ("PBGC") to receive a 4% equity interest in the Company upon emergence from the Chapter 11 Proceedings in exchange for any termination- related claims it may have against the Debtors and their "controlled group members." As of December 2009, the Company estimated that this claim could total approximately $460 million.

So in exchange for terminating their $460M claim, the PBGC gets 3.8% of the equity ... whereas management / directors are getting 10% of the equity when they collectively owned less than 1% of the company as of Feb 2010...

So back to the original question: Why did the bonds and stock rally so hard?

The company reported results well ahead of the aforementioned plan projections in which the valuation was based on:

• Sales came in at $6.69B vs 2009 plan projections of $6.45B
• Adjusted EBITDA of $454M vs plan projections of $302M

Weren't the projections completed in December? And you were off my $150M in EBITDA? Explanation?

"Our restructuring, ongoing cost-reduction initiatives and ability to keep overhead costs aligned with reduced sales helped drive significant year-over-year improvements in cash flow and earnings, despite significantly lower vehicle production volumes and challenging industry conditions," said Visteon Chairman and CEO Donald J. Stebbins.

Man - I never realized costs can be ratcheted down that dramatically in the last 2 weeks of the year. Color me surprised!

More recently, if you have been following the docket, you would have also know that a lot of action is going on behind the scenes - specifically those related to alternative plan structures which was really the catalyst for the initial bump in the bonds in the first month of the year. Lots of people want to own the equity of this company obviously - And to get the equity of this company, within the exclusivity period, you need two things:

1. Management on board - how to incentive them? With a big check.
2. A valuation assessment where your class consequently becomes the fulcrum security ... i.e. low enough that no one behind you gets equity, but large enough to be plausible.

Could one have predicted prior to the recent earnings announcement that Visteon was going to show a huge EBITDA number? I think so - with the right amount of due diligence combined with a bar being set low (for whatever reasons) can create for some interesting distressed debt investment opportunities.

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Distressed Debt Ideas for 2010 - General Motors

One of few things I like about dealers in the investment grade, high yield and distressed debt space, is that each year, around this time, the various desk and publishing analysts from the different investment banks put out lists of buy and sells in the corporate debt space. These events are always well attended and can sometimes provide a fruitful ground for generated distressed debt investment ideas for the new year.

Over the next few weeks, in tandem with some work I am doing on a few new websites / blogs, and of course the Distressed Debt Investors Club, I will be discussing a number of these ideas in detail. Given that the HY / Distressed market has backed up in the past week and half, I think we are not going to miss any rip-roaring opportunities...(maybe Visteon on a court decision?).

Admittedly, I am neither long nor short any of the names I am going to be discussing (Sandbag much?). Rather, what I am trying to accomplish is to help the reader understand some of the intricacies involved in analysis ranging from investment grade to distressed debt. We are going to start with a favorite of many in the space: General Motors.

General Motors filed for bankruptcy protection in June 2009. After much public debate/discussion, GM (hereafter referred to as "Motors Liquidation Company"), sold the majority of its assets to the new GM in a 363 sale. As noted above, there was much debate in this sale, as the U.S. Treasury funded the purchase and became new GM's largest shareholder.

The pre-petition bonds of Motor's Liquidation currently trade in the market in the high 20s context. Like we have discussed in previous posts, one now needs to figure out the asset and liability structure of the corporation in question. In other words: What are the assets and liabilities of Motors Liquidation?

The most meaningful asset of Motor's Liquidation (really the only asset) is an equity and warrant stake in new GM ("Newco"). We need to somehow value that which we will get to in a second. The liabilities of Motor's Liquidation are where things get a little trickier...

The unsecured claims pool in large complex cases, like Enron, is a very difficult number to pin down. For example, in GM, here are some of the liabilities that an analyst needs to estimate:

1. The exact amount of claim from the pre-petition unsecured bond debt...including accrued interest per tranche.
2. Monies owed to affiliates
3. Accounts payable
4. Accrued expenses
5. Environment reserves
6. Union obligations
7. Worker's comp obligations
8. Litigation and other product liabilities
9. And other which is a catch-all for everything else (for example: dealer rejection claims).

If you ask two different desk analysts on the street to quantify these numbers, they will give you different answers on each line item. Further, most of these liabilities are subject to compromise, meaning an unsecured creditor might file a claim, and that claim could be rejected. In November, Motor's Liquidation filed a monthly operating report that tried to nail these numbers down. You can see that file here: GM November 2009 MOR. There is also some very specific nuances with double dip claims at two finance Co's of GM. In all likelihood, that number presented in the MOR will be different as claims come and go.

Since we know we now need to compare assets versus liabilities, and our one asset is the equity in NewCo, we need to figure out how much NewCo is worth. For that, we can either use the experts valuation model, or model the company ourselves. From the people I have talked to across the Street, analysts are making assumptions on the SAAR in the outer years, GM's eventual market share of that SAAR, GM's variable profit/vehicle, GM's fixed costs, and then estimating the cash flow of GM's overseas operations. They then apply a multiple to these cash flows, back out the debt, and get the equity value of the equity.

Remember, Motors Liquidation has both an equity stake and a warrant stake in NewCo. After exercising these options, it looks like Motors Liquidation will own a little more than 23% of NewCo (thank you tax payer!). Therefore if you think new GM's equity is worth, $10B, Motors Liquidation would have an asset value of 2.3B. If there were then $35B of claims, all else being equal, those claims would be worth a little more than 6 cents on the dollar.

Let's be a little more realistic. I built a quick little model using the aforementioned variables, and came up with $8B of North American EBITDA in 2012 and $3B of overseas EBITDA in 2012. Capitalizing these numbers 5x and 6x respectively, gives me a valuation of $58B. Backing out the post-petition debt and preferred stock of NewCo of approximately $29B, leaves me an equity value of $29B. But wait...there' more. Lots more.

The cash balance at GM is massive right now. At 9/30/2009 that cash balance was $42B. Assuming a standard burn of $10-12B, leaves us with ~ $30B in cash. Let's add that back to our $29B to give us an equity value of a little less than $60B. Owning 23% of that beast, gives you a valuation of assets to Motors Liquidation of ~$13.8B.

And how does this compare to our claims pool? Let's be conservative, take the MOR number noted above, add in the double dip claims, and then add another billion of allowed claims to get to $35B. Given that ~$28B is claims from these old GM notes we are discussing means that as a % of the claim pool, approximately 80% is related to the notes. Then if our value of the equity is $13.8B, 80% is going to the notes, or $11B. $11B divided by the $28B in bond claims give you a value of approximately 40 cents on the dollar.

Now there are so many variables that can change this number DRAMATICALLY. For example, we could of used a 4x cash flow number for North American EBITDA. We could of used a much lower SAAR number. We could of used a much higher market share number. And even if we ARE getting 40 cent on the dollar, we have no idea when we will be getting distributions. What if it take 5 years? That would be a return in the 11-12% range which would definitely not compensate us for the risks involved.

This is definitely a complicated case. Everyone likes to talk about it. And its definitely a 8 or 9 foot poll if you are using Warren Buffet parlay. It shows you some of the little steps that one goes through in this type of analysis. Hopefully in the future, we will be able to update the analysis with more clarity on our numbers, and feel more comfortable about our distressed debt valuation.

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Third Avenue Focused Credit Fund

If you have been reading this blog for any sort of time, you would know I am a big fan of Marty Whitman and the Third Avenue family of fund (especially the new Third Avenue Focused Credit Fund). Marty has penned a number of fantastic books on value investing and distressed debt investing:

Distress Investing: Principles and Techniques

Value Investing: A Balanced Approach

The Aggressive Conservative Investor

I have read all three of these books and I can personally recommend each of them. I actually will eventually do a whole series on Distress Investing - as I think a lot can be learned from the book and from Marty's wisdom.

This morning, a colleague of mine sent me the Third Avenue Four Quarter 2009 Portfolio Manager Commentary. It is a quarterly ritual of mine to read the various fund manager's commentary on the market and new positions entered / exited throughout the quarter.

As many are aware, Third Avenue launched the Third Avenue Focused Credit Fund earlier this year. I think this is a fantastic vehicle for individual investors investing in the credit space. Their commentary this quarter is also full of gems. Here are some quotes / paragraphs I particularly enjoyed:

INVESTMENT OBJECTIVE AND FUND STRATEGY

The genesis for the Fund was driven by a market opportunity in credit that Third Avenue had not seen since the early 1990s. As our colleagues have written about in the other Third Avenue Funds Shareholder Letters, debt became a bigger focus in 2008 and early 2009. Indeed, due to our history and credit heritage, Third Avenue has always had a proclivity to invest in credit and special situations. However, what was occurring in the credit markets were, as Marty Whitman so aptly put it, “investments of a lifetime.” Similarly, it was clear that you, our shareholders, were making inquiries about a credit only product. We believed that a differentiated credit fund with daily liquidity where the Fund Manager would pick the best investments across the bank loan, high-yield bond and busted convertible bond universe was the best structure. Clients also wanted some exposure to distressed investments, given the higher default rates and Third Avenue’s twenty-three year track record of distressed investing.

We designed the Fund to be differentiated from other credit and high-yield mutual funds in the following ways:

1) The Fund utilizes a value-oriented investment process that relies on extremely thorough and intensive fundamental research;

2) We focus our capital on our highest conviction ideas based upon our fundamental credit research – the Fund will normally have 50-70 investments;

3) The Fund has an opportunistic mandate that can invest in any part of the credit spectrum;

a. Bank loans, high-yield bonds, busted converts or distressed securities;

b. Invest in the security with the best upside potential versus downside risk;

4) The investment team must identify an event or catalyst to drive value and the security price higher.

I honestly could not of put it better myself. Point 4 is so important to my investment process that it bears repeating - I always look for a catalyst when I go out and seek compelling ideas - I do not want to be in a situation where a security may be undervalued by 20-30% but it takes 4 or 5 years to get there.

The letter then goes on to detail a number of situations, according to how they categorize the security, in which I have historically or currently been involved in (I will not differentiate between the two to keep you guessing): These include: HCA, Swift, Aleris, CIT, and Marsisco. Every reader should read this section as it details the rationale behind investing in performing bonds and loans, stressed credit, capital infusions, distressed credit, and debt for equity reorganizations. Again the letter can be found here: Third Avenue Shareholder Letter

In relation to CIT, I will write up a very long and detailed post about it before the holidays. We have looked up and down the capital structure for a number of months and think some of the securities could be appealing.

And finally, on the outlook for the future for distressed debt opportunities:

Notwithstanding that the high-yield market returned 49% and the lowest-rated CCC debt issuances returned more than 90% in 2009, we believe there are significant investment opportunities for the Fund on the horizon. In particular, we believe we are still in the early-to-middle innings for distressed investment opportunities.

The strong high-yield markets have certainly enabled some larger companies to temporarily delay the inevitable default, while giving others a chance to grow into their capital structure. During the first nine months of 2009, $121 billion of high-yield debt has been issued. This has predominately been used to repay existing shorter-dated bank and bond debt. As a result, the near-term maturities of some companies have been pushed out. Nonetheless, we note that the net debt position has not improved and, in fact, free cash flow has deteriorated due to the relatively higher interest rates associated with the new issuances. For some companies, this will provide enough time for their businesses to grow into their overleveraged capital structures. However, for others it will simply delay the liquidity event and need to restructure.

I couldn't agree more. Please visit Third Avenue's Website and spend some time reading past commentary as well as the great things going on with Marty Whitman and his team. You will not be disappointed.

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Distressed Debt Concessions

When investing in distressed debt, one has to be aware that negotiations can affect a creditor's ultimate recovery - for the good or the bad.

Why does this dynamic occur? More appropriately, what influences a creditor's decision to negotiate in a bankruptcy proceeding? As noted quite often in this blog, the bankruptcy process is expensive. Lawyers are billing upwards of $1000/hour. If a certain creditor class wants to expedite the bankruptcy approval process, they may give up some "nuisance value" to junior creditors to get their support.

In addition, in the wake of fraudulent conveyance rulings, senior creditors, specifically at the bank debt level, do not want to see their liens extinguished by a litigation from subordinated creditors. So they have even more incentive to offer up a little value to get junior creditors to play ball with a confirming bankruptcy plan.

The bankruptcy case of Idearc, which we spoke about quite a long time ago (Idearc Bankruptcy), is an example of negotiations among various creditor classes. Here is the new proposed Idearc bankruptcy plan.

As you can see on page 22 of 50 of the file, the plan outlines the treatment of Class 4 Claims, which in this case represents, the unsecured bond holders. Furthermore, we can see the edits on this document:

1. Bondholders were to get 5% of the new common stock - They are now getting 15%
2. Bondholders were to receive no cash - They are now getting $120M

Why did this happen? If you have been following the Idearc bankruptcy, you would have known that MatlinPatterson and the unsecured creditors, via the Unsecured Creditor Committee, was challenging the bank debt lenders and the bank debt agent on possible unencumbered assets at Idearc (from the docket):

The Creditors’ Committee commenced this adversary proceeding in order to challenge certain of the Agent’s liens and the valuation and allocation of the Debtors’ unencumbered property, if any, pursuant to the Debtors’ proposed plan of reorganization. The Creditors’ Committee contended that there are significant unencumbered assets, including the Debtors’ copyrights and related revenue streams, and rights to use the Verizon brand, as well as post-petition revenue streams, and that the value of such assets should be distributed to unsecured creditors. The Agent rejected the Creditors’ Committee’s contentions, maintaining that (a) the Agent held a perfected pre-petition lien, for the benefit of the Lenders, on substantially all of the Debtors’ assets, (b) the Creditors’ Committee’s challenges to the Agent’s liens on the Verizon brand and the revenues associated with the Debtors’ copyrights were without any merit, (c) the value of the Debtors’ copyrights were de minimis, and (d) the challenge to the Agent’s lien on post-petition revenues was defeated, among other things, by the diminution in value of the Debtors’ estates since the bankruptcy filing, and the Agent’s right to be adequately protected by receiving a post-petition replacement lien on whatever unencumbered property existed. This litigation ensued, extensive discovery was taken, and trial commenced and was conducted on November 9th and 10th.

Now, I have no opinion one way or the other on the validity of these claims. I do know, though, that these claims brought the various creditor parties to the table to work out an "amicable" solution. A lengthy litigation may have dragged the bankruptcy process on substantially longer, thereby accruing more lawyer fees, and possibly harming the underlying business of Idearc

The docket continues:

Now, following the commencement of trial on the myriad legal and factual issues implicated in this dispute, the Parties have reached a global resolution of all issues. The Settlement described herein preserves a significant recovery to the Lenders on account of their secured claims, while significantly increasing the consideration to be paid to Class 4 unsecured creditors under the Debtors’ plan of reorganization, and paves the way for the Debtors’ prompt emergence from Chapter 11.

So, to drop their dispute, the Class 4 creditors (the bond holders), got the aforementioned benefits: $120M in cash and a large percentage of the post-re org equity. In addition, the new bankruptcy plan has the support of a large creditor class thereby bringing the confirmation of the case that much closer.

Who won out in this exchange? In all honesty, probably everyone won out - except the bankruptcy lawyers. Note holders get a bump in recovery (the bonds have been gradually trading up over the last 3 months), bank debt holders do not have to worry about losing massive value, and the company will emerge from bankruptcy faster. Win/Win for all.

Happy Thanksgiving from Distressed Debt Investing!

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Interesting Thoughts from a Credit Trader

A friend sent me this commentary from a credit trader at Deutsche Bank. Quite interesting commentary, especially given where credit spreads have moved in from:

In the past month we have been traveling a lot visiting clients and co-workers across the globe. The purpose of this was twofold, first we wanted to sell the New DB to the world. In our opinion we have built the best trading desk on the street and we have made great progress in converting ourself into a flow desk selling idea's and providing liquidity. Second we wanted to get a first hand snapshot of the new buy-side landscape, clearly the world has changed in the past year and we wanted see and talk to some of the new and old players that make up the new mkt. Although we have many more clients to see we would like to provide you with some interesting take aways from my trips.

1) CASH The cash on the sidelines is real and building, there is still billions of dollars on the sidelines and the number is growing everyday. Coupons and bonds rolling off are creating 100mm's a day at individual insurance companies on top fo the billions they already had, this cash may or may not be invested into the credit mkt's but its there and praying for a back up in spreads to deploy into credit. Many accounts are still seeing new mandates flow into the credit space including pension money being allocated to credit from equities thus the buying of 30yrs. There is no indication that the cash on the sidelines and the cash still coming into credit will change any time in 2010.

2) The dollar, rates and spreads We found it interesting that outside the US they are much more bullish on the dollar than many accounts we saw in the US. The dollar and its potential negative impact on rates was given by many US accounts as one the main risks to a continued recovery. We spoke to several European accounts about dollar mandates they either had or were close to getting, if you look at US spreads vs Euro or Sterling mkts its clear why they are interested in dollar debt. Almost everyone expected rates to be much higher at the end of 2010 than today, and that is why the new issue books for front end bonds is out of control. We did not find many accounts that thought spreads would be wider, almost everyone thought that IGs could get to the 60-70 area. That being said most accounts were looking at HY for performance next year, and many spoke about having compression trades on.

3) Basis and leverage We found more basis buyers and we were told by many that they expect basis to go from negative to positive in 2010, and we now have more accounts looking for HY basis than in the past few months. More than a few mkt participants spoke of having more leverage at their disposal now than they have had for some time. Very few thought that the correlation mkt would come back in the form it had but most thought the need for yield in the second half of the year would produce some bespokes with small amounts of leverage. Just a few weeks ago we got hit on some 8yr cds vs a new deal being done, the mkt was split on if that was a one of or if we will see more deals.

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Fraudulent Conveyance

Before getting to our lesson on fraudulent conveyance, I would like thank those that have applied to the Distressed Debt Investors Club. The rate of applications coming in is better than I expected. I am humbled by the response of our readers. Remember, we will take applications through next weekend before the site is opened up to admitted members. Apply soon!

This post continues our series of Advanced Distressed Debt Topics. You can find the first two posts at:

Advanced Distressed Debt Lesson #1

Advanced Distressed Debt Lesson #2

This week we are going to be discussing fraudulent conveyance. Section 548 of the bankruptcy code deals with transactions that are fraudulently made. While malicious transfers are also dealt with in the bankruptcy code (i.e. doing something purposefully to malign creditors), we are going to be focusing on the more "practical" kind of fraudulent conveyance.

Now, I know this is technical. And believe me, it will get more technical. But the concept of fraudulent conveyance is literally never more important than it is today. Why? The simple reason: The Tousa Ruling. Here is the relevant docket and the actual fraudulent conveyance ruling by the judge.

The ruling is 182 pages. I am not going to do it the mis-justice of simply summarizing it in a few lines. For those that really want to understand how judges make decisions in these sorts of cases, it is imperative you read the ruling.

To prove a transfer is fraudulent, one must not only prove the absence of reasonably equivalent value granted, but also that the entity doing the transfer was insolvent at the time. Section 548 of the bankruptcy code looks back 2 years - so in addition to the two concepts above, this transfer must have also happened in the last two years.

If you look at the docket mentioned above, you will see a litany of appeals and "clarifications of judgement and order" as well as "findings of fact" which are all actions that try to reverse this judge's decisions. They are all fascinating reads. I am going to pull out 7 or 8 blocks of text from various filings and comment on them as I think that will enlighten the readers the most. But first, just a little background on the case.

In July of 2007, Tousa, a homebuilder, borrowed $500M and granted lenders security in all their assets. This capital was used to settle litigation against Tousa and one of its subsidiaries (Transeastern) because of a default at the Transeastern JV. The problem was, Tousa had other subsidiaries, that were not party to the litigation / lawsuit. Tousa, and subsidiaries subsequently filed for bankruptcy in January 2008. The creditor committee, i.e. those holding unsecured claims against Tousa, was seeking to avoid the $500M debt/lien obligation and avoid liens on a tax refund issued in 2007.

As a quick summary, and this is a broad based statement, but I am going with it: If a lien is shown to be "fraudulent", that lien is effectively worthless. That means a secured creditor would now be an unsecured creditor. This is important because now instead of getting a piece of the pie after the secured lenders get paid off, everyone gets their fair share.

A simple example will suffice:

Say a company has $100M in assets. This company also has $100M in debt secured against those assets and $100M of unsecured debt. With a simple bankruptcy waterfall we see that the secured lenders will get 100% of their claim ($100M of assets / $100M of secured debt) and unsecured creditors will get 0% of their claim ($0M of remaining assets / $100M of unsecured claims).

Now lets say those liens are worthless. The $100M of assets would now be split between $200M of unsecured claims ($100M voided secured debt + $100M of unsecured debt) with a recovery of 50 cents on the dollar for each. With liens, unsecured lenders are getting donuts. Without the liens, they are getting 50 cents on the dollar back.

In this 182 page ruling, the judge lays out the case/reasoning behind the claims he is postulating. For example, he lays out the housing downturn and the effect it had on Tousa's business, including management communication with advisers and investors at the times. My favorite:

In a May 25, 2007 email to himself, Wagman stated that TOUSA “will fail” to satisfy covenants in its bond indentures “into late 2008 or 2009. Not even close.” Ex. 2113 at 1-2 (emphasis added). He noted the view of the rating agencies that the homebuilding industry was “grim and getting grimmer,” with downward pressure on prices and margins. He wrote, "As CFO, and in light of all of this market uncertainty, I have absolutely no desire to fly this plane too close to the ground, achieve some from [sic] of consensual settlement today and crash within the upcoming year. That would be a clusterf*ck."

I really hope I'm not the only one that thinks this line is incredible.

The judge continues discussing "contemporaneous evidence" suggesting that the Tousa subs were insolvent at the July transaction, they were left MORE insolvent as a result of said transaction, left them too small a capital base, and left them unable to pay their debts as they matured.

For example: "Prior to the July 31 transaction, Citi harbored significant doubts about TOUSA’s solvency, but – motivated by the prospect of substantial fee income – pressed forward nonetheless" ... Quoting from the ruling

"Citi saw the proposed new financing as a highly attractive opportunity for fees. In a March 23, 2007 email, Citi employees discussed their strategy of structuring the deal so that, even in a worst-case scenario, Citi would lose less than its fees. Citi ultimately collected approximately $15 million in fees for the transaction, including funds paid to its advisers by TOUSA. Citi was keenly aware of its ultimate goal. In early March 2007, when TOUSA requested an amendment of the Revolver to relax the interest coverage ratio and avoid a going concern opinion from its auditors, Citi assented to modifying the covenants because “[a] going concern [opinion] would not be

particularly helpful in putting in place the $1.2B financing we’re working on, as you know, and for which we are slated to earn roughly $8mm in fees."

The judge goes on like this for quite some time, getting into things as deep as not being able to trust a certain expert's witness testimony or the use of certain discount rates when doing a valuation. Deep deep stuff.

Moving to the "Conclusions of Law" section where the judge lays out his ruling in relation to the bankruptcy code, we can start to figure out what all this fraudulent transfer talk really means. For example

"Section 548(a)(1)(B) permits the avoidance of any transfer of an interest of the debtor in property, or any obligation incurred by the debtor, that was made or incurred within 2 years before the date of filing of the petition, if the debtor voluntarily or involuntarily received less than a reasonably equivalent value in exchange for such transfer or obligation and (A) was insolvent on the date that such transfer was made or such obligation was incurred, or became insolvent as a result of such transfer or obligation, (B) was engaged in a business or transaction, or was about to engage in a business or transaction, for which any property remaining with the debtor was an unreasonably small capital; or (C) intended to incur, or believed that the debtor would incur, debts that would be beyond the debtor’s ability to pay as such debts matured. 11 U.S.C. § 548(a)(1)(B)."

And using the law, the judge discusses the evidence and arguments laid out (like in the examples above) to show that point A, B, and C of USC 548(a)(1)(B) was indeed the case at Tousa. This continues going deeper and deeper, digging into what "unreasonably small capital" means for example, or how the inability to pay debts can be shown. This is great learning for all those interested.

In the end, the judge ruled that all claims of the First and Second Lien Lenders (from the July 2007 transaction) and all liens granted by the subsidiaries are to be avoided and disallowed (i.e. everyone is unsecured). ALSO, the judge ruled that the Transeastern lenders (that had gotten paid back with the $500M July 2007 deal) need to disgorge to the subsidiaries $403M plus interest. Yes, you thought you got paid out, but now I want the money back. And to knock them in the teeth, the tax refund liens were also disgorged.

Now, as I mentioned, everyone is appealing this thing. Everyone. And tomorrow, we will look at their reasoning and the arguments they are making. This fraudulent conveyance case has wide reaching implications for distressed debt investors in the future (and current cases as well). We will also discuss that tomorrow.

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