Distressed Investing Conference Notes: Part II (including Wilbur Ross comments on shipping sector)

Last week, we reported notes from the Beard Group's 18th annual Distressed Investing Conference. Distressed Debt Investing contributor Josh Nahas, Principal of Wolf Capital Advisors, a Philadelphia based investment advisory firm focused on distressed debt and corporate restructuring, was in attendance. Here is more notes from the conference:

Baggage & Benefits: Current Issues in the Ownership of Distressed Debt and Bankruptcy Claims

Panelist:

• Paul N. Silverstein, Panel Moderator, Partner/Co-Chair Bankruptcy & Restructuring Practice, ANDREWS KURTH LLP
• Geoffrey A. Richards, Group Head, Special Situations and Restructuring, WILLIAM BLAIR & COMPANY L.L.C.
• Jane Sullivan, Executive Vice President, EPIQ BANKRUPTCY SOLUTIONS

The first topic discussed was credit bidding and the Philly News and Palco decisions and how those decisions were unfavorable to secured creditors who, prior to those rulings, had always assumed to have an absolute right to credit bid except in the case of malfeasance. Section 363(k)of the bankruptcy code allows for credit bidding except for “cause” which the 3rd circuit in Philly News went to define broadly, not just a bad act.

However, in In re River Road Hotel Partners LLC the 7th Circuit affirmed the bankruptcy court’s ruling, rejecting the debtor’s bid procedures motion on the grounds that it precluded credit bidding. In that case, the court took the same approach as the dissenting opinion of Judge Ambro in Philly News which was based on the principles of statutory construction. There is now a split between the 7th Circuit and the 3rd and 5th Circuits and the appellate circuits as to the interpretation of Section 1129(b)(2)(A)’s “fair and equitable” standard. River Road along with another debtor in a similar case RadLax have appealed the decision to the Supreme Court.

Issues relating to the risks of trading with Plan Support Agreements ("PSA") were discussed. One result is that creditor will be required to disclose exact amount of holdings. Counter parties need to know whether they actually hold title to instruments (assignment vs participation) and whether the securities are held currently or out on loan. It was recommended that if you sign a PSA it is best not to sit on the UCC because of potential conflicts in your fiduciary duties.

Next, the panel tacked the issue related to WAMU and post-petition interest. The panel viewed as a troubling and unsound decision where a ruling by Jude Walrath of the US Bankruptcy Court in Delaware held that creditors with a contract rate of interest (bondholders) of a solvent debtor were only entitled to Federal Judgment Rate on post-petition interest. In the opinion, she admittedly disavowed her previous statements in In re Quorum Healthcare Corp where she had upheld post-petition interest at the contract rate. She did uphold a contractual subordination clause between the Sr and Junior lenders that will require the junior lender to turn over their recovery to the senior lenders until the senior lenders have recovered their post-petition interest.

The panel all agreed that as a result, investors should be modeling base case recovery waterfalls in solvent debtor case assuming judgment rate not contract rate, at least for cases in Delaware until there is more clarity on the issue.

Perhaps the most disturbing and far reaching decision for distressed investors is Judge Walrath’s findings with regards to potential insider trading claims. In her ruling, Judge Walrath found in favor of the equity committee having a “colorable” claim of insider trading against members of a steering committee which had formed to negotiate a settlement with the debtor. The 4 fund group had established provisions for cleansing of inside information, and lifting of trading restrictions when negotiations had closed. The panel believed that this decision may significantly impact the ability and willingness of creditors to actively participate in negotiations with debtors. This could increase the time it takes to get a deal done in bankruptcy, as well increase the amount of money spent litigating, rather than negotiating.

The last issue the panel briefly touched on was Judge Kevin J. Carey’s decision to reject both plans in the Tribune bankruptcy. Carey said neither plan was confirmable but appeared to favor Tribune’s plan, labeling the competing plan as “speculative.” The issue surrounds Fraudulent Conveyance claims against those who financed the 2007 LBO of the company. There are questions surrounding the ability of the creditors to step into the debtor’s shoes and pursue the claims, since fraudulent conveyance actions are prosecuted by the debtor on behalf of the estate.

Transportation & Shipping: Investment Tips & Traps

Panelists

• Wilbur L. Ross, Chairman and Chief Executive Officer, WL ROSS AND CO. LLC (Pre-Recorded Statement)
• Edward O. Sassower, Panel Moderator, Partner, KIRKLAND & ELLIS LLP
• John P. Brincko, President, SITRICK BRINCKO GROUP, LLC
• Mark Friedman, Senior Managing Director, EVERCORE
• Daniel G. Montgomery, Managing Director, MESIROW FINANCIAL CONSULTING, LLC
• Steven Strom, Managing Director and Global Head of Restructuring, JEFFERIES & CO.

Wilbur Ross opened with a 20 minute overview of distressed shipping sector. He spoke via a pre-recorded video as he was in Ireland meeting with regulators about his investment in Bank of Ireland. Mr. Ross spoke briefly about his investment in Navigator Holdings and Airlease, however he spend most of his time providing an astute overview of distressed shippers.

In the distressed shipping sector, he first noted that the majority of ships are financed by European banks which are under increasing strain and have dramatically curtailed lending. Shipping is already struggling due to the glut of ships that have come on the market from the mid 2000s boom as well as from declining economic activity. Moreover, shipping is still a highly fragmented industry with few barriers to entry. There are a large number of charter operations with 1 or 2 vessels who compete aggressively on price. He noted that currently shippers require $4 of assets to generate $1 of revenue, not a recipe for good returns on capital. With charter rates down over 45% from their 2007 peak, Mr. Ross predicted that the market would not reach equilibrium for at least another year if not more.

As a result of these factors Mr. Ross predicted that the next couple years would be difficult for shippers and that the way the industry finances itself would be fundamentally transformed and that private equity and alternative investors would play a significant role. He believed that banks were going lower the LTVs that they lend against to the 50% range while they previously had been closer to 80%. He noted that a great deal of ship financing over the last several years came from German KG tax shelters, but indicated that this source of funding was not likely plays as big a role going forward.

In addition, he felt that the current opaque corporate structures where operators are competing against their public company owners would need to change and that the business would need to become more transparent. Mr. Ross predicted there would be opportunities for those who funds willing to take a long view and capable of dealing with the multi-jurisdictional issues and untangling the complex corporate structure.

Moving to the panelists in attendance, John P. Brincko, President of Sitrick Brinkcko who specializes in the trucking space spoke on the current problems facing the sector. He pointed out that the business has become heavily commoditized, is highly fragmented with many independent owner/operators and has little pricing power. To make matters worse many of the truckers, including YRC which went through a restructuring are saddled with expensive union contracts. He felt the companies with expensive labor contracts, and particularly YRC, would likely need to file for bankruptcy to reduce operating costs and remain competitive.

Other panelists noted the free fall bankruptcies of Omega Navigation and Marco Polo and said those cases could influence future restructurings in the shipping space. Steve Strom of Jefferies cited Omega as an example of a foreign shipper filing in the US as a good test case. (Jefferies is advising the debtor). Mark Friedman of Evercore noted that there are a large number of publicly traded shippers priced under $10 per share with 12-15 shipping companies trading at $2. He thought many of these names could be good short candidates.

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Beard's 2011 Distressed Investing Conference

Earlier this week, the Beard Group, publisher of Turnarounds & Workouts and the Troubled Company Reporter held the 18th annual Distressed Investing Conference. Distressed Debt Investing contributor Josh Nahas, Principal of Wolf Capital Advisors, a Philadelphia based investment advisory firm focused on distressed debt and corporate restructuring, was in attendance. Over the next week or so, we will be providing notes from the various panels at the conference.

The first set of notes focuses on cross-border insolvency, with a particular focus on Canada. Panelists included:

• Harold L. Kaplan, Panel Moderator Partner/Leader Corporate Trust and Bondholder Rights Team, FOLEY & LARDNER LLP
• Allan S. Brilliant, Partner, DECHERT LLP
• Robert J. Chadwick, Partner/Member Executive Committee, GOODMANS, LLP
• Nigel D. Meakin, Senior Managing Director, FTI CONSULTING
• Stuart Swartz, Senior Vice President, COMPUTERSHARE TRUST COMPANY OF CANADA
• Claudia R. Tobler, Counsel Bankruptcy and Corporate Reorganization Department, PAUL, WEISS, RIFKIND, WHARTON & GARRISON LLP

Enjoy!

Cross Border Insolvency

A multinational distressed company’s ability to maximize its restructuring potential requires careful planning and an understanding of the issues raised by competing and potentially co-equal insolvency regimes.

When to file, and whether a deal can be reached out of court is important. When to pull the plug on negotiations for successful out of court restructuring is influenced by regulatory regime. In Canada, the Canada Business Corporations Act allows for holdouts in an out of court restructuring to be bound by a 2/3 majority vote. Makes out of court deals easier and deals with free rider problem. In US, most consensual deals will not work without 90% of holders or better due to free rider problem.

Where to file is heavily influence by DIP lending capacity. Also, US creditors have aversion to CCAA in Canada because there is no UCC. As a result, both Smurfit and Abitibi/Bowater resulted in both concurrent CCAA and Ch 11 proceedings which increased the cost to the estate dramatically. The alternative is a CCAA action with a corresponding Ch 15 filing in the US.

A CCAA with a corresponding Ch 15 filing would allow for a much lower estate costs as administration fees in Canada are much lower compared to US filings according to the panel. Several panelists noted that if the role of a monitor was better understood there may be less aversion to using CCAA and a Ch 15. The monitor is chosen by the Debtor, which to some in the US gives the appearance of impartiality. However, the monitor is tasked handling many of the matters the UCC would tackle in a restructuring.

Since most of the negotiations between the monitor and the debtor happen behind closed doors, the monitor is wrongly viewed as not being a strong advocate for creditors. However, according to panelist Nigel Meakin of FTI the monitor actually can be a forceful advocate and usually the debtor will come to terms with monitor, because if the monitor appeals to the court, judges will generally defer to the monitor’s decision.

Another difference between US and Canadian insolvency is the role of indenture trustee. The Indenture Trustee does not play the same forceful role or have the same fiduciary obligations as US indenture trustees do. Stuart Swartz, of Computershare the largest indenture trustee in Canada highlighted the top 10 difference between US and Canada indenture trustee.

1. Indenture Trustees unfortunately still cannot claim diplomatic immunity when acting on cross-border deals.
2. When working with an indenture trustee on a cross border default, get the counsel and parties collaborating as soon as possible.
3. In Canada, rating agencies view indenture trustees differently than in the US.
4. Canadian’s don’t do Committees like in the US.
5. In Canada, there is no need to act unless funded and provided with an indemnity in advance.
6. Industry practice in Canada and US shapes discussions as does market size and number of industry players. Trustees are expected to be much more active in the US than in Canada. Other regions vary as well. The use of discretion by the trustee will vary greatly in each region.
7. Canadian trustees don’t create conflicts due to lending situations (re: Successor Trusteeships are more common in the US due to these conflicts).
8. Trustees are advocates and not experts. This is why we retain the right to hire and rely upon advisers
9. Regardless of jurisdiction, it is the overall goal of the indenture trustee to maximize return of investment to the holders when acting in a default situation.
10. As with this presentation, indenture trustees are never given enough time when first called upon. Please reach out as soon as you can.

The panel then tackled some case studies starting with Qimonda, a German bankruptcy with concurrent Ch 15 proceedings. Debtor sought to invalidate intellectual property licences in order to re-auction them and gain more value to estate. German courts would allow, however, objections in US Ch 15 proceedings court would not allow them to do so based on Section 365(n) of BK Code United States Bankruptcy Court for the Eastern District of Virginia, holding that fundamental U.S. public policies of fostering technological growth and innovation, determined that the protections of section 365(n) apply to licensees of a foreign debtor’s U.S. patents.

The Court held that by a joint reading of sections 1521(a)(7) and 1522 of the Bankruptcy Code, strongly favored the application of section 365(n) with respect to the U.S. patent portfolio of Qimonda, a foreign debtor, and (b) permitting a foreign debtor to use foreign law in a chapter 15 case to non-consensually terminate various U.S. patent licensing agreements would be “manifestly contrary to the public policy of the United States” pursuant to section 1506 of the Bankruptcy Code.

The Vitro case was then discussed. Vitro SAB is a glass manufacturer with US subsidiaries and $1.2bn in US$ denominated unsecured debt. The company filed a “pre-pack” under Mexican statute by creating post default $1.9bn in inter-company loans to dilute bondhodlers and vote in favor of debtor’s plan. Per the indenture, inter-company loans were expressly subordinated to the bonds. However, the court allowed the inter-company claims to be used for the purposes of skipping the preliminary phase of case and filing a pre-pack. The Debtor then proposed a plan that invalidated the bondholders subsidiary guarantees and heavily favored the existing equity holders at the expense of legitimate creditors. A concurrent Ch 15 was also filed in the US.

A Conciliador or Conciliator was appointed by the Court tasked with reaching a settlement between the noteholders and debtor. The settlement proposed by the Consiliador put the bondholders in a worse position than before and was rejected.

Meanwhile litigation in New York was initiated by Wilmington Trust in its capacity as indenture trustee with respect to Vitro’s 2012 and 2017 bonds with a combined $1 billion outstanding. These securities were guaranteed by many of Vitro’s US subsidiaries as well as others and the indenture expressly acknowledged that it was governed by NY law and that “any rights and privileges that such Guarantor might otherwise have under the laws of Mexico shall not be applicable.” Wilmington argues as a result of NY Law governing the indenture that the guarantees cannot be avoided by the holding’s insolvency proceeding in Mexico. A ruling from the court in NY is expected soon. The belief is that the NY court will rule in bondholders favor and thus forcing Vitro back to the bargaining table.

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Notes from Chicago Booth's Annual Distressed Investing and Restructuring Conference

We were fortunate enough to have the organizers of Chicago Booth's 6th Annual Distressed Investing and Restructuring Conference take notes for us. Enjoy!

MORNING KEYNOTE:

Howard Marks, Chairman, Oaktree Capital Management

• Dean Harry Davis, who taught Howard Marks, introduces Marks with a discussion about the importance of Art and Study and how those themes run through Marks’s career.
• Marks gives an overview of the distressed investing space and the current cycle. He notes that while thousands of people can do similar analysis the difference lies in the art of interpretation.
• Marks walks through the history of each distressed debt cycle, noting that each cycle is similar to past cycles: unwise extension of credit combines with economic weakness to offer plentiful opportunities in the distressed debt space.
• The cyclical pattern is the same with tight post-recession credit conditions leading to solid credit quality, which then leads to strong returns, which then pushes more money into the space allowing for poor quality issuance, which eventually produces high defaults and a period of risk aversion.
• The second half of the talk was a case study of Favorite Brands with Marks explaining how to analyze the capital structure and why Oaktree bought at every level of the capital stack.
• In terms of fund management while having an ability to take positions in large size trades gives an access to unique opportunities, having a lot of assets under management is not always a good thing in terms of efficiency and client management. Quality of investments is the key.
• He also noted that an investor must make conservative assumptions, but not so conservative that it prohibits putting money to work.
• Prospective Commercial Real Estate opportunities will depend on whether financial institutions face the reality of the buildings' prices going down from their original levels and how regulators treat loans.
• Basel II will require European investors to face value drops and this may lead to distressed investment opportunities there.

Legal Panel

Moderator: Donald Bernstein, Davis Polk & Wardwell LLP

Panelists:

Douglas Baird, University of Chicago Law School

Ashley Keller, Bartlit Beck Herman Palenchar & Scott

Damian Schaible, Davis Polk & Wardwell LLP

Christopher Sontchi, US Bankruptcy Judge, District of Deleware

• Chapter 11 was designed to provide legal mechanisms to restructure companies but more recently has been used more by the investors than management. Panel discussed how the Chapter 11 process has been transformed with regular players who use it as a way to source investments.
• Discussion of reorganizations versus 363 sales. At times, reorganizations are the best solution as a 363 asset sale at a certain period in time may not provide the best price. Yet, the reorganization process does not consider the fact that debt is being traded and there are no clear-cut rules on how the court should deal with investors having different incentives and positions in various parts of the capital structure.
• In recent reorganizations, there has been increased importance of "gifting" where senior creditors give junior creditors some value to be able to come to an agreement.
• Credit bidding has become an important trend and it provides a good option in situations of market failure (example of Delphi where the only bid was 15% of the DIP financing amount). Discussion of whether Philly News will be precedent setting.
• The role of CDS protection holders in the restructuring space has become an important topic. Their incentives differ from other distressed investors because of the ability to get paid when CDS is triggered by a credit event such as bankruptcy.
• The revival of capital markets activity with covenant-lite loans and PIK-toggle loans is coming back in vogue. This should lead to plenty of bankruptcy work.
• There seems to be a lot of loan amendment activity, as well, which may indicate more distressed opportunities down the road.
• Issues with deal sourcing in the current environment due to high demand from distressed investors and new players in the space.
• A great number of current activities in the space are from hedge funds which lead to prolonged periods of negotiations when it comes to handing over the keys to the company.
• Another side of the coin here is that should credit markets freeze, we are to expect a severe drop similar to Q2 2008.

Private Equity Panel

Moderator: Darin Facer, AlixPartners

Panelists:

Duncan Bourne, Wynnchurch Capital

Ron Glass, GlassRatner Advisory & Capital Group LLC

Paul Halpern, Versa Capital Management

Michael Oleshansky, Industrial Opportunities Partners

• Some panelists thought that the downturn would have gotten a lot worse before getting better
• One panelist noted that they never expected creditors to be as patient as they have been (relating to the many amendments and extensions)
• It was also mentioned that some investors thought that interest rates would have faced more upward pressure by now
• The panel also discussed the importance of implementing operational changes in the portfolio companies The panel spoke about ways they are sourcing deal flow and specific sectors / industries they are looking at.
• Current environment is also a good one for monetizing private equity investments due to active capital markets.

Investment Banking Panel

Moderator: Nat Gregory, Professor, University of Chicago Booth School of Business

Panelists:

Dan Aronson, Lazard

Mona Baruah, Rothschild

Jeffery Finger, Miller Buckfire

Andrew Turnbull, Houlihan Lokey

• Much of the discussion centered on the question, “Is the recent distressed cycle done?” Panelists contrasted the low-level of deal-flow today versus the hectic period of 2008/2009
• Lack of deal-flow mainly attributed to the improvement in the global economy, the prevalence of covenant-lite loans during the recent credit boom, and the flexibility of debt holders
• In light of decreased activity in the space, panelists mentioned that some banks are pushing their related capital markets platform (specifically, negotiating amend & extends and sourcing new capital for struggling companies)
• Panelists predicted that the high level of covenant amendments might result in another distressed cycle in the 2013-2015 timeframe (when a maturity wall of ~$600bn will come due)
• Many companies (despite having pushed out their maturities) will still be underwater and will eventually have difficulty refinancing sizeable issues
• Panelists also discussed the popular topic of distressed municipalities and the general consensus was that many municipalities are facing real distress
• Panel worried about how fast credit spreads have tightened, how quickly banking activity has returned to near 2007 levels. The financing business cycle has been compressed by massive U.S. stimulus programs, leaving open the possibility of a fairly quick return of frothiness in underwriting, then to another credit crunch.

Distressed Investing Panel

Moderator: David Small, Grosvenor Capital Management

Panelists:

Eric Baer, Chicago Fundemental Investment Partners

David Miller, Elliott Associates

David Trucano, Centerbridge Partners, LP

Michael Watchorn, PIMCO

• Panel began with each investor discussing strategy and talking through an investment. Names discussed included Quebecor World, Delphi, Tribune and an unnamed finance company.
• Panel then turned to the current location in the distressed cycle. They worried about how fast credit spreads have tightened and how liquidity returned so quickly. Panel is generally cautious on fixed income assets and particularly sovereign debt.
• They turned attention to the shift to the increasing sophistication of investors in bankruptcies and how the smaller sophisticated claim holders can obtain higher returns.
• The panel turned to sourcing opportunities. It was emphasized that in determining new opportunities investors should look for businesses owned by unnatural owners.
• Panelists agreed on the companies facing commodity pressure (both agricultural and oil) will face hard times in the next two years.
• Another source of opportunity will likely be Europe due to both fiscal crises and changing financial regulations.
• Panelists discussed whether it is better for young investors to be generalists or specialists, with the panel divided on which is best. One consistent theme was repetition and muscle memory and an emphasis on being part of lots of investments.

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Distressed Debt Conference: 2011 Wharton Restructuring Conference

Each year, I try to highlight some of the best distressed debt conferences I come across. This year we are starting the year off right highlighting the 7th Annual Wharton Restructuring and Turnaround Conference. Panelists from a number of the best and brightest distressed debt funds including Brigade, SVP, and Avenue (Marc Lasry is a keynote speaker) will be speaking on a number of fascinating topics (GGP case study looks particularly interesting).

For all those interested and want more details, please follow the link below:

http://whartonrestructuringconference.org/index.html

And if you have a restructuring or distressed debt conference you think would be of interest to our readers, please contact me: hunter [at] distressed-debt-investing.com

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Distressed Debt Investing interviews Mark Berman

We are very excited to bring you an interview with Mark Berman, founder and Managing Partner of MB Family Advisors, LLC and the MB Dislocation Opportunity Fund, L.P., a dislocation / distressed credit fund-of-funds. MB Family Advisors, LLC is a multi-family office investment firm founded in 2008 to manage investment portfolios for ultra-high net worth families across asset class, with a particular focus on alternative investments and investing in inefficient markets.

Mark will be speaking at the upcoming Global Forum on Investing in Distressed Debt, coming up this month in NYC. If you remember, this is an event I have helped to organize. I really hope all my readers will attend.

Enjoy the interview!

Mark - Could you give us a little bit of background on yourself and MB Family Advisors?

Sure. In a former life I started my career as an M&A attorney at Skadden, Arps but I’ve been a principal investor since 1994, mostly in firms where I was a Founder or Co-Founder and invested substantial personal capital alongside my investors. Initially I focused on small and mid-market buyout investing and had some great success as well as luck (for instance our marquee buyout transaction generated a return of almost 60x our equity investment). I started investing in hedge funds in 1997, both single manager and fund-of-funds. In 2001, seeing the inefficiencies in the private equity secondary market I co-founded a fund firm that purchased in the secondary market limited partnership interests in real estate private equity funds. The common theme to my investing career has been to focus on finding inefficient markets where a provider of scarce capital can generate outsized returns.

The search for inefficient markets required that I develop deep experience across multiple asset classes – private equity, hedge funds, credit markets, real estate etc. This broad experience led to the launch of MB Family Advisors, LLC in mid-2008 when I formalized a relationship with an anchor investor to manage his family’s investment portfolio across asset class. The anchor investor has a low 9-figure net worth. The intention has been that over time I would add additional family clients and on occasion offer specialized investment products that could opportunistically target particularly inefficient opportunities.

The first investment product came in January 2009 when I launched the MB Dislocation Opportunity Fund, LP, a dislocation/distressed credit fund-of-funds. The Fund is intended to provide investors with diverse exposure across a variety of different credit, distressed and other niche strategies including traditional long/short corporate distressed; asset based lending; structured credit; merger arbitrage; and mortgage debt markets (RMBS/CMBS & whole loans), among other strategies. The common denominator in all the Fund’s allocations is that we invest in strategies positioned to benefit from ways the capital markets have changed since the 2008 financial crisis.

We have to say, a January 2009 launch of a distressed credit fund-of-funds seems incredibly prescient. When you were looking out at the world at that time, why did you think that was the opportune time to invest?

Well, for starters I’d note that it’s more of a “dislocation” fund than pure distressed credit. As indicated, we’ll invest in any strategy we think has benefited from the 2008 financial crisis. Distressed debt is just one of the underlying strategies.

As for timing of the Fund’s launch, as I alluded to I think the best investment opportunities come from inefficient markets. As capital markets imploded in the Fall of 2008 credit markets in particular became so highly dislocated. Credit completely froze. While there was substantial continuing uncertainty regarding the severity of the recession it was already clear by year-end 2008 that the US and other developed country governments would not allow the complete collapse of the financial system. However, the complete lack of liquidity and fear associated with uncertainty created forced and/or highly motivated sellers resulting in substantially mis-priced securities and assets.

The mis-pricing existed across multiple markets including leveraged loans, ABS, DIP lending, ABL lending and others where all of a sudden you could target high, equity like returns or better investing at the most senior, least risky part of the capital structure. I wanted in on that action.

To get sufficient diversity of strategy and manager I decided to launch the fund-of-funds and take in outside investor capital. In hindsight our timing was good. It’s still early but we’ve enjoyed great success thus far and have generated positive returns in 18 of the 20 months since launch.

We see you have had tremendous success to date - What are your thoughts on the distressed market today? Do you worry that so much capital has entered the space over the past 12 months that returns going forward could be squeezed out?

The nature of the opportunity set has changed. Initially the opportunity existed to get 20%+ returns on high quality, performing assets that were not distressed but were trading at distressed prices. That trade is over.

For reasons I’ll describe, over the next 12-18 months I think there are other niche strategies more compelling than distressed corporate debt. However, there are attractive opportunities currently in some mid-market distressed names and beginning in late 2011 or early 2012 the overall distressed market will become extremely compelling again.

To me it’s clear that we’re in the midst of what will be a multi-year distressed cycle. The upcoming wall of debt maturities has over $1 Trillion in corporate debt coming due (and this excludes mortgage debt), much of which was issued in the go go years of 2005-07 and is stuck in unsustainable capital structures. Sure, “amend and extend” has kicked the can down the road but for many of these companies the day of reckoning will nevertheless come. At that point there will be a huge supply/demand imbalance in favor of distressed debt investors and 20%+ return potential will exist again.

Several high yield analysts have recently opined that all the debt extensions are solving the wall of debt maturity problem but I think they are misguided. High yield issuance is at record levels but something like 70% - 80% of the issuance has been for tenders to replace existing debt and extend out maturities. Yes, this has resulted in default rates coming way down for large cap companies that can access the high yield market. It’s true that this makes the distressed opportunity set much less attractive in the near term --say over the next 12-18 months -- but this is a temporary phenomenon. While you can solve a liquidity problem with more debt you generally can’t solve a balance sheet problem by issuing more debt unless growth is so robust that substantially higher cash flow can meaningfully shrink leverage and coverage ratios. (Unfortunately this is a lesson our government hasn’t yet learned but that’s a topic for another day.) The prospects for this type of hyper growth in cash flow are quite slim.

So, in the near term there will be fewer large on-the-run names in the distressed space and returns will be squeezed but with a little patience distressed debt will be quite compelling again. In any case, it’s important to appreciate that through Q2 of this year default rates for small and mid-cap companies were still in excess of 10%. These companies do not have access to the high yield market and have far fewer options to kick the can down the road. Therefore, in my view the most attractive distressed opportunities for the next year or two will be in the mid-market. This is an important consideration when assessing who to allocate distressed capital to.

Perhaps that’s a lot to digest but the bottom line is that I think (A) over the next 12-18 months there is more opportunity in other niche credit strategies like direct and asset based lending, (B) within distressed the best opportunities in the next 12-18 months are going to be in mid-market names and (C) as the day of reckoning on the wall of debt maturities gets closer, the overall distressed market will become extremely compelling again and offer 20%+ potential returns.

When you are looking to allocate capital to a manager, what do you look for? Do you tend to allocate across smaller funds or larger funds?

We take a portfolio approach so it’s very important the individual component allocations fit together well. To some extent this means limiting correlation among underlying managers, each of whom has to bring something different to make it into our portfolio. We intentionally have a mix of small and large funds. Generally speaking our bias is for funds that use no or limited leverage; that don’t have 2008 legacy problems either in their portfolio or business; and have a stable underlying capital base.

With regard to individual manager decisions, like most allocators it’s important for us to understand what the particular manager’s “edge” is and get comfortable with the manager’s superior talent, ability to source ideas, integrity, commitment to best practices in back office and reporting, and passion generally for what they do.

In addition, three super important hot buttons for us are (i) interest alignment, (ii) risk management and (iii) world class investment process. If we aren’t 100% comfortable with these issues then nothing else matters. I’d note that process generally is under-appreciated among many investors. Great results come out of great process, period. We’re much more focused on seeing a rigorous, disciplined and repeatable process than we are on recent historical performance.

Continuing on allocation, when looking at your group of portfolio managers in which you have invested, how do you determine which manager will get the next dollar of your investor's capital? Does it depend on the underlying portfolio manager's strategies?

Yes, strategy is critical. Going forward I believe the best investors will distinguish themselves by being in the right strategies, as the environment will be ripe to reward certain strategies and punish others. While there’s no substitute for talent and motivation, a B+ manager in a strategy with substantial wind at its back will substantially outperform an A+ manager in a strategy with headwinds. I am extremely attuned to this in portfolio construction and it does heavily influence the allocation of incremental investment dollars.

It also drives occasional redemption decisions. Early this year I redeemed from a credit fund that generated net returns of 45% in 2009. It was a difficult decision in that the manager was talented and had really delivered for us. However, it was a long-only fund focused on a particular segment of the credit markets. That segment had rallied so substantially to the point that the opportunity set going forward no longer presented a compelling risk-reward profile– so I redeemed.

The other consideration that’s also critical is liquidity. Different funds have different lock-up and notice requirements and, at least in managing the Dislocation Fund, we have to make sure we don’t risk an asset/liability mis-match. This is less important in managing the family office portfolios but even there you want to make sure you are being compensated if you’re giving up liquidity.

Among the strategies in which you allocate capital (traditional long/short corporate distressed; DIP lending; merger arbitrage; asset based lending; fixed income arbitrage; asset backed securities; structured finance; and mortgage debt markets), where do you see the most opportunity today? The least opportunity?

Our strategy allocations are driven by the broad thesis that the dislocation experienced since the 2008 financial crisis will persist for multiple years, creating both opportunities (and risks). There are three primary drivers of our opportunity set:

(1) The wall of debt maturities – as discussed earlier there is over $1 trillion of high yield debt and leveraged loans coming due (nearly $4 trillion if you include mortgage debt). Much of this will eventually need to be restructured which feeds classic distressed debt investment strategies;

(2) The availability of capital is highly bifurcated: for companies large enough to tap high yield, credit is widely available -- but for companies with less than $50M in EBITDA and those looking for asset based loans credit is still extremely scarce. This creates opportunity for those managing direct lending and ABL funds to invest at the most senior, least risky top of capital structure but still get high equity like returns; and

(3) Certain strategies are positioned to benefit from the deleveraging because far less capital is chasing the spreads. An example of this would be low risk merger arbitrage where spreads are materially higher than what they were a few years ago because prop desks have shrunken and hedge funds have far less leverage available.

Over the next 12-18 months I think the most attractive strategies fall out of the 2nd and 3rd drivers – i.e. those that can be a provider of scarce capital and/or those benefiting from deleveraging. In particular I think direct lending, asset based lending and merger arbitrage are quite attractive right now – offering the potential to generate equity like returns without equity risk. In addition to the attractive return profile, if executed properly they are relatively low risk and, importantly, come with little or no correlation to the public equity or fixed income markets.

We know many emerging distressed and credit hedge fund managers will be attending the IQPC Global Forum on Distressed Debt coming up in September. We know many smaller managers have difficulty attracting the attention of fund of funds. Could you shed some light on things emerging managers could improve to better attract outside investor capital?

Fundraising is difficult for emerging managers. In my view the best positioned emerging managers are those with a differentiated strategy. If it’s not differentiated the bar is so much higher as new funds do have higher business and operational risk.

That said, the data is clear that as AUM increases manager returns decrease. Emerging managers could do a better job of highlighting this data – it’s strange but I don’t see it that often in emerging manager pitch books. Many talk about their ability to focus on off the run names but don’t necessarily draw the cause and effect relationship supported by empirical data. Good allocators should already be aware of this but I think emerging managers would be well served by highlighting it more. Emerging managers that are committed to capping AUM at a certain size for a defined period of time may also send a message to investors that they are more focused on generating high returns than on high fees.

Of course, in today’s environment an emerging manager has to be committed to best practices with respect to back office, operational and reporting functions. Operational due diligence has taken on a heightened level of importance and it’s easy to say no to a good investor with only mediocre controls. This can be challenging for an emerging manager who has less resources than a larger fund but nevertheless the emerging manager needs to demonstrate this commitment if they want to attract institutional capital. Likewise, having a highly credible Administrator, Auditor and Prime Broker is also important.

Finally, for me interest alignment is critical with all managers but even more so for an emerging manager. That means it’s often a non-starter if a substantial majority of the manager’s net worth isn’t invested in their fund. You take a little bit of a leap with any emerging manager but can get a higher level of comfort if the manager has a larger investment than you do in his or her fund and is essentially managing their own capital and you’re along for the ride.

When we do invest with an emerging manager we’ll generally start small and build the relationship over time.

You have been incredibly successful in setting up a number of investment partnerships. What is next for you?

Never say never, and I suppose it’s possible the umbrella I operate under could change, but at this point it’s hard to see me doing anything else. This is an incredibly fascinating time to be an investor. The investment landscape has changed dramatically since the 2008 financial crisis. There are so many opportunities and so many landmines, and the intellectual exercise of navigating that balance is more challenging and rewarding than anything I’ve done professionally to-date. I love how I spend my days. The challenges and uncertainty also place a higher premium on talent, which I hope accrues to my benefit.

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Distressed Debt Conference

Last month we announced to readers that we were helping organize The Global Forum on Investing in Distressed Debt. In the coming weeks, we will be bringing you in depth interviews with a number of conference presenters talking about the major issues going on in the distressed debt market today. Before we get to that though, I wanted to take a little time out to discuss what I think the primary benefits are of attending a conference like this.

Distressed debt is, in my opinion, one of the most lucrative opportunities to intelligent investors because it requires a substantial amount of knowledge, both on the valuation as well as technical/legal side. 98% of investors out there will look at a distressed situation and say: "Too complicated - Pass" or "I don't understand this case - sell the paper." That is where the opportunities arise.

Today's distressed market is characterized by ever increasing complicated bankruptcy proceedings - In addition, the onset of a more and more pre-packs means the distressed investing professional needs two things: technical knowledge and as many contacts as possible.

The Global Forum on Distressed Debt Investing promises to provide attendees with both benefits. The current list of presenters is absolutely incredible - ranging from very experience bankruptcy attorneys to buy side professionals who can intelligently talk and extract certain nuances from today's distressed debt market. This is an invaluable resource to market participants. For example, soon we will have an interview on the site with one of the nation's leading experts on fraudulent conveyance - And given the vast amount of cases that are going that route (in one fashion or another), you have to be equipped with that knowledge to intelligently invest in this market.

Professional contacts are key in this market. Any distressed conference provides a fantastic avenue for meeting up with different players in this market, whether it be restructuring professionals, lawyers, the sell side, or buy side investors. In my opinion, this conference in particular, given its extensive schedule, will bolster these networking opportunities. In a market where forbearance agreements and pre-packs are the norm, the investor with the most contacts will surely have a better chance at being at the negotiating table, where IMO, the real money is made.

We hope you attend the Global Forum on Investing in Distressed Debt coming up in September. If you have any question, feel free to shoot me an email.

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Global Forum on Distressed Debt

It gives me great pleasure to announce a partnership between Distressed Debt Investing and IQPC in the upcoming 6th annual Global Forum on Investing in Distressed Debt. Over the last 3 months, I have worked with the organizers of this fantastic event in bringing together a group of speakers and presenters that I feel will be a significant value add to Distressed Debt Investing readers.

Over the next few months, we will bringing you interviews with participants in the conference. These people come from a variety of backgrounds ranging from lawyers to analysts to portfolio managers. In each conversation, I hope to bring our readers a unique perspective to the distressed debt investing process.

We encourage you to visit the conference homepage by clicking on the banner ad to the left. If you have any questions about the conference, its organizers, or its speakers, please shoot me an email at hunter [at] distressed-debt-investing.com.

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Chicago Distressed Investing & Restructuring Conference

Wanted to send a quick note out about the Chicago Distressed Investing & Restructuring Conference coming up on April 16th, 2010. Looks to be a very solid conference - professionals from distressed debt hedge funds, creditor and debtor restructuring advisors, a bankruptcy judge(Chris Sontchi - one of the more prominent judges in the Delaware bankruptcy court), and other bankruptcy professionals will be speaking on a number of different topics.

You can find more details about the conference here: 5th Annual Distressed Investing and Restructuring Conference

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Corporate Restructure Conference

Earlier in the week, we had note from Wharton's Restructuring Conference. We continue with Part 2 of the restructuring conference with more notes and commentary:

One of the two morning sessions was a case study panel that discussed the Charter Communications restructuring. The panel included most of the key parties involved in this historic case, which was the largest pre-arranged bankruptcy filing ever.

Panelists:

Cyrus Pardiwala of PricewaterhouseCoopers as moderator (no role in Charter)

Richard Cieri of Kirkland Ellis – Debtors’ counsel

Gregory Doody – Executive Vice President and General Counsel, Charter Communications

Alan Kornberg of Paul, Weiss, Rifkind, Wharton and Garrison LLP – Bondholder Committee Counsel

James Millstein – Senior Restructuring Advisor, U.S. Department of Treasury (Formerly Lazard financial advisor to Charter)

Eric Zinterhofer – Senior Partner, Apollo Management

Mr. Millstein walked the audience through how Charter’s “Byzantine” cap structure came into existence through a multitude of bond issues. For those unfamiliar to Charter, the company had one of the most convoluted corporate structures known to man. Although the Charter operations were generating cash, the company’s highly leveraged balance sheet required access to the high yield bond market to refinance maturities. With the complete shutdown of the new issue market in 4Q08, Charter’s auditors refused to issue a going concern opinion. This is what precipitated the restructuring.

At this point (December 12, 2008) the restructuring advisors began approaching bondholders regarding a debt restructuring. Most bondholders were shocked by the announcement because the company had the cash to continue making interest payments and assumed the runway was much longer. Once bondholders got past the initial shock, they (mostly) agreed that avoiding a freefall bankruptcy was a must. Both the company and creditors feared an “Adelphia-like bankruptcy” that would destroy a lot of value via a protracted valuation fight.

On January 15, 2009 the company announced that two of its subsidiaries did not make their scheduled interest payments. Mr. Millstein referred to this as “the hammer” to get more bondholders to the table during the 30-day grace period. It was around this time that the “cram up” idea was hatched. For those unfamiliar, the cram up was a new twist on reorganizations last year whereby senior debt is reinstated if all events of default can be cured prior to emergence. In fact, Mr. Cieri noted that the original idea came from a consumer bankruptcy case where an individual reinstated his car loan.

The bank debt reinstatement was the crucial part of the Charter case because the firm had several billion dollars of senior secured bank debt with a LIBOR+250 interest rate, which they guessed was anywhere from 500 to 700 bps cheap to where a new loan could get done. Obviously, JP Morgan—the agent bank—opposed being reinstated, although Mr. Millstein had a funny anecdote about how they at first didn’t even understand what the company was attempting to do. Were Charter unable to reinstate the bank debt, there would have been a much longer bankruptcy case that would have destroyed value and “killed” many of the junior creditors. This fight eventually resulted in a 19-day hearing where JP Morgan’s attorneys argued that Charter was violating a covenant in the credit agreement that prevented any group from owning more than Paul Allen. The attorneys argued that the bondholders committee amounted to a “13-d group” and thus violated the covenant. Backing up a bit, a huge part of the plan was Apollo putting up $1.6 billion for an equity investment. The company’s lawyers argued that the ad hoc committee did not constitute a group under rule 13-d because they purchased their bonds at different times, different prices and for different reasons.

Ultimately, Judge Peck sided with the company in an 82-page opinion that the panel agreed would be the lasting legacy of the case. { Judge Peck’s opinion } Mr. Kornberg made some interesting observations about how the JP attorneys essentially shot themselves in the collective foot by stating from the outset of the case that they were out to get their clients higher interest payments. He believes that judges have little sympathy for unimpaired creditors when junior creditors are a) taking a haircut and b) putting in new money.

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Restructuring Conference

Distressed Debt Investing attended the Wharton Restructuring Conference this past Friday in Philadelphia. As usual the conference featured an outstanding lineup of leading distressed investing world players including hedge fund managers, bankruptcy attorneys and restructuring advisors. We note that the conference is an exceptional value at $125, a fraction of the cost of most non-sell-side industry events. We will do a series of posts over the coming week with the highlights of the conference.

http://whartonrestructuringconference.org/index.html

The morning keynote speaker was Bennett Rosenthal, Senior Partner, Ares Management LLC.

His bio from the conference website:

“Bennett Rosenthal is a Senior Partner in the Ares Private Equity Group and sits on the Executive Committee of Ares Management. Mr. Rosenthal is the Chairman of Ares Capital Corporation. Mr. Rosenthal joined Ares in 1998 from Merrill Lynch & Co. where he served as a Managing Director in the Global Leveraged Finance Group and was responsible for originating, structuring, and negotiating many leveraged loan and high yield financings. Mr. Rosenthal was also a senior member of Merrill Lynch’s Leveraged Transaction Commitment Committee. His transaction experience is both acquisition and non-acquisition related across a broad range of industries including retail, telecommunications, media, healthcare, financial services and consumer products. “

Mr. Bennett gave an overview of Ares, described their investment strategies and shared his thoughts on the various markets in which they transact. Below are some of his thoughts in bullet format.

• Ares is a $33 billion LA based firm
• They have 3 groups: Private Equity, Liquid/Capital Markets, Private Debt
• 20 industry analysts, which provides them significant depth in every sector, this also helps generate private transactions
• Recent volatility of emotions has made it difficult to invest
• The early ’09 “bottom” was misleading because it was a small window of time that was hard to take advantage of; very few transactions
• Still see a great opportunity for liquid markets to generate excess returns, but it won’t be a beta driven rally like 2009
• Going forward it will be about credit selection
• In the leveraged loan market 30% of loans trade below 90% of par, excess return will come from refis and covenant repricings
• CLOs are back but w/ less leverage
• Seeing good opps in the 2^nd lien market
• HY spreads of +600 still offer “great opportunities”
• Senior secured credit at L+300 is great value
• The largest opportunity is senior secured bonds of refinanced leveraged loans at double digit yields
• $1 Trillion of maturities in the next 4 yrs
• Last year the “loan to own” investors were paid to wait, this is no longer the case
• LBOs – they are getting propped 6x deals again
• Ares has a business development corp (“BDC”) – there they are moving down into mezzanine loans from senior secured
• PE biz has four pillars: Rescue, Distressed for control, LBO, Growth equity
• They view distressed for control as an auction w/ few bidders
• Not a turnaround firm, they don’t want to replace management
• “Mission in life” is finding good companies w/ bad balance sheets
• They always try to buy the fulcrum security and get a seat at the table
• Simmons was a signature transaction for them, perfect example of how restructuring advisors can drive a transaction
• He noted the advantage of having deep pockets at the trough. Most other buyers—financial and strategic—are too scared or too tight on cash to buy things
• Always look for the security that trades at the multiple they believe the business is worth and then have the cash to pay off the people above them

Stay tuned later in the week for part 2 of the Wharton Restructuring Conference

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Distressed Debt Conference

If you remember, a few months ago I posted about a distressed debt networking event at the Harvard Club. I regularly attend these conferences and events for three reasons:

1. Learning about investment ideas and themes in the current market
2. Meeting with other distressed debt investors
3. Getting my name out there for future capital raising endeavors

All three of these are quite vital in the current environment. Even if you follow a number of situations very closely, you never know what alpha generating ideas people are digging up in their corner of the sandbox. And in an environment like today (Madoff, hedge fund gates, etc), canvassing more like-minded pools of capital is a win-win for those trying to start their own fund or investment vehicle.

One such networking event / conference coming up in September is the Global Distressed Debt Investing Conference right here in New York City. I know, or have worked with a number of the presenters in one capacity or the other (one presenter, currently not shown on the agenda is arguably the best distressed investor out there right now, and he rarely speaks in public - more from him in a few weeks). Looking like this is going to be a top notch conference.

Hope to see you there!

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