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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Advanced Distressed Debt Lesson #2

In our first edition of Advanced Distressed Debt learning / knowledge base, we discussed negative pledges. In this post, we will discuss the issue of exclusivity.

The exclusivity period is the period after the bankruptcy petition date in which only the debtor can file its Chapter 11 plan. This is advantageous in that the company can work out its own version of how it sees fit in financing itself going forward - without creditors pressing for actions / solutions that may peril the debtor, but also peril the debtor's management team.

Section 1121 of the bankruptcy code gives exclusivity to the debt for the first 120 days after the bankruptcy petition is filed. If a plan is filed in this period, the debtor is given another 60 days (i.e. a total of 180 days), where no other plan may be filed. The judge of the case, as usual in most bankruptcy cases, can make this period longer if the debtor so requests, or can shorten it if creditors move against the debtor's exclusivity.

Before the new 2005 bankruptcy rules, exclusivity could of lasted for a very very long time. Companies that filed prior to the new bankruptcy rules are still able to drag out the bankruptcy process many times to the chagrin of creditors. Very few of those cases remain (W.R. Grace is one as an example). Any filings after the 2005 rule changes, the exclusivity period (i.e. 120 and 180 days respectively) may not be extended past 18 months and 20 months respectively.

If the debtor fails to file a plan AND get creditors on board within these aforementioned periods, Wild West sets on the bankruptcy court, and anyone may file a plan.

Why is this all important? Given that the window of time for a debtor to file a plan has been maxed out to the 18-20 month period, management many times has to really reach out and deal with creditors if they want to keep their jobs. Further, 363 sales, because of the swiftness in which they can be accomplished, are being pursued a lot more frequently than prior to the new 2005 bankruptcy law changes. But most importantly: It creates an avenue for distressed debt investors to position themselves better than being handcuffed by obstinate management teams intent of keeping their positions.

We have discussed Six Flags' bankruptcy at length on this blog. The company has proposed a plan (within their exclusivity rights) to give over 90% of the new equity to bank debt lenders. Unfortunately, the subordinated OpCo notes do not like this plan and have laid out its own ideas what the restructuring should look like. And the market has concurred: Six Flags' OpCo notes have marched to the high 80s (from 50s earlier in the summer), as the market anticipated that the currently filed plan will not be accepted and more than likely amended to give some juice to the OpCo notes.

It turns out that the company has been working on a new plan. But at the same time, it has asked for an extension of exclusivity, which everyone and their mother has objected to (I very much enjoyed and suggest you read this entire document: Six Flags' Exclusivity Objection)

I do not know who will win the battle here. I have been invested in the Six Flags' bank debt since I first posted about it in April when it was trading in the low 70s. The return is significantly lower, but the downside risk is also quite muted. If management's plan is confirmed, you are creating the company at a ridiculously low valuation, and if the OpCo note holders plan is confirmed you get taken out at par (make some carry and a few points here). To me, that is still the best place to play in the capital structure, from a risk/return, especially given the run-up of the OpCo notes.

Later in the weak, I am going to do a two part series on fraudulent conveyance - an issue ripe for a Distressed Debt Investing post given the recent ruling at Tousa.

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Wisdom from Seth Klarman - Part 4

If you are new to the blog, here is part 1-3 from our "Wisdom from Seth Klarman" series.

Wisdom from Seth Klarman - Part 1

Wisdom from Seth Klarman - Part 2

Wisdom from Seth Klarman - Part 3

In this edition, we will take a look at Baupost's 2006 Annual Letter. And before I get to it, thank you to Andy for his donation (for those so inclined, a donation link is on the right rail, lower in the page). More donations = the better.

In 2006, Baupost's various funds ended the year up between ~21.4 to 22.8%. This is in comparison to the S&P which was up 15.8% that year. Gains were made from a number of categories with approximately 7% of absolute gain coming from performing and non performing debt - with the largest gain coming from "unnamed non-performing debt" which I speculated in last post was a position in Enron. These results are even more impressive given that cash/cash equivalents were 48% of the fund at year end. ROE therefore was over 40% during the year.

After discussing the party that was 2006, Klarman writes:

"We maintained our discipline throughout the year: disciplined buying when bargains emerged, and disciplined selling when prices approached full value. Despite fairly expensive markets, robust competition, and a near complete dearth of distressed debt opportunity, our tireless, highly capable, and experience team was able to fairly regularly uncover new opportunities. Considerable fundamental progress in many of our holdings, along with our strong selling discipline, triggered realizations during the year that were approximately equal to new purchases, resulting in relatively flat cash balances that masked substantial underlying activity.

One adverse in evidence during the year is that the markets proffered fewer extreme mispricings, and a relatively greater number of moderate ones. Beneficially, the velocity of the correction of these mispricings accelerated. In other words, fewer investments become really inexpensive, more become somewhat inexpensive, and the correction of these smaller mispricings happened faster than usual, enabling a particularly favorable overall result for us and for many value-oriented investors. It is impossible to know if this paradigm will continue, although the proliferation of ever-vigilant and opportunistic hedge funds and increasingly private equity pool suggest that it could.

The old saw reminds us never to confuse genius with a bull market. Anyone can become "expert" at buying the dips, and recent market conditions have amply rewarded dip-buyers with quick gains. It will not always be so easy; slight bargains don't always compliantly rally. Sometime minor bargains become major ones, and sometimes great bargains turn out to be not as cheap as you thought. Eras of quite low volatility and general prosperity are often followed by periods of disturbingly high volatility and economic woe. Meanwhile, for the undisciplined, "buy the dips" can drift mindlessly into "buy anything"; a rising tide that is lifting all boats often proves irresistible."

This guy must have a crystal ball. Remember he wrote this in January 2007. He is also somewhat pointing the finger (I am sure unintentionally) to many of the value investors that kept buying and buying all throughout 2nd quarter of 2007 - 2008. I remember reading an interview with a prominent value investor saying that Freddie Mac was one of the cheapest stocks he had ever seen - and he just kept buying and buying it.

After talking about the sheer magnitude of capital flowing into alternative investments (hedge funds, venture capital, and private equity), fueled by demand from institutions and pensions:

"Many of today's institutional asset allocators are not evidently worried about the enormous amounts of capital surging into alternative investments. They are now asking the relevant bottoms-up question: Where are today's bargains? They are not following that thread to build, investment by investment, or one carefully chosen fund at a time, a diversified portfolio of undervalued investments. Instead, they are typically focused on the answer to three questions, each of which demonstrates a reluctance to think for themselves:

1. What has worked lately?
2. How can I diversify my way to investment success?
3. How can I invest like the institutional thought leader of this era; in other words, like Yale?

Here's why these questions range from remarkably foolish to largely irrelevant.

Investing is mean reverting. What has outperformed lately will not, and cannot, grow to the sky. Sustained out performance in any particular sector of the markets is eventually borrowed from the future, to be given back either slowly through sustained under performance or quickly through price declines. What has worked lately is popular, widely owned, and bid up in price, and therefore generally anathema to good future results. But human nature makes it extremely difficult for people to embrace what has recently fared poorly."

And further down the letter...

"The idea that you should own a little bit of everything is a concept rooted in market efficiency. If the markets are efficient, you cannot outperform anyway, so by owning a bit of everything in just the right proportions, you stand to reduce portfolio volatility, what at least avoiding under performance. This is the best that you can hope to do in an efficient market.

For any fundamental-based investor, this is complete hogwash. Investment come in the following varieties: undervalued, fairly valued, and overvalued. Price is everything, and every investment is undervalued at one price, fairly valued at a higher price, and overvalued at some still higher price. You buy the first, avoid the second, and sell the third. Having a goal of diversification, rather than owning value, causes investors to take their eye off the ball. It is a refuge of investment wimps, owning a little bit of everything to avoid being wrong, but thereby ensuring never being really right either."

I love it. Too many times, each of us get caught up trying to look at some many things that our heads spin. A number of value investors suffer from a problem I fondly dub "Everything is cheap syndrome" ... after you study Buffet, Graham, and Klarman you start looking at everything, and lots of the things you look at you think are cheap. Any investor can rationalize a price target for any asset. The goal is to be patient and swing at those once in a lifetime opportunities, and then not dilute those returns with mediocre value traps.

"Given how hard it is to accumulate capital and how easy it can be to lose it, it is astonishing how many investors almost single-mindedly focus on return, with a nary of thought about risk. Lured into their slumber by the 'Greenspan-now Bernake-put', an investment mandate of relative and not absolute returns, as well as a four-year period of generally favorable market conditions, investors seem to be largely oblivious to off the radar events and worst-case scenarios. History suggests that a reordering of priorities lies in the not too distant future."

The first rule of investing is to not lose money. And the second rule is to not forget the first rule. When approaching situations, always look to the possibility and magnitude of permanent capital loss. I remember watching Alice Schroeder (author of The Snowball) at an event a year or so ago and she mentioned that Warren Buffett will not invest in a situation where there is even a remote chance of permanent capital loss.

Stay tuned later in the week when Distressed Debt Investing finishes its analysis of the 2006 Baupost Annual Letter.

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Advanced Distressed Debt Lesson #1

Over the next few months, in addition to regular postings, I would like to delve into some of the more archaic distressed debt investing concepts and technicalities. While a strong ability to value companies (especially those that are facing tough times) will get one far in this business, being able to see the intracies of bankruptcy rulings, credit agreements, indentures, etc will enable you to looks at more delicate and difficult situations where many investors will avoid due to the sheer complexity. At times I will use current or past examples, and at others I will speak conceptually of lessons I have learned over the years. Remember, I am not a lawyer - just a practicing professional investor that has a few thoughts and opinions.

We will begin with negative pledges. A negative pledge is a restriction, embedded in a bond's covenants that prohibits liens on certain properties unless the bonds are equally and ratably secured. The key with a negative pledge is defining "certain properties." In all indentures and credit agreements, capitalized terms will be defined in a "Definitions" section. For example, in one of Darden's Indenture:

"The Company will not, and will not permit any Restricted Subsidiary to, incur, issue, assume or guarantee Indebtedness secured by any Liens of the Company or any Restricted Subsidiary upon any Principal Property, or upon shares of capital stock or evidences of Indebtedness issued by any Restricted Subsidiary and owned by the Company or any Restricted Subsidiary, whether owned at the date of this Indenture or thereafter acquired, without making, or causing such Restricted Subsidiary to make, effective provision to secure all of the Securities then Outstanding by such Lien, equally and ratably with any and all other Indebtedness thereby secured, so long as such Indebtedness shall be so secured."

The problem with this statement is that every capitalized term has a definition, and those definitions may be wide open. Let's see what Principal Property means. Going to the definition section:

“Principal Property” means all restaurant or related equipment and real property, in each case which is owned by the Company or a Subsidiary and which constitutes all or part of any restaurant located within the United States or Canada.

Hmm. What about assets overseas (if there are any?). What about intellectual property? What about accounts receivable? What about stock? A stock pledge can be very valuable at times. Seems like quite a bit of things could be pledged to secure debt if things got bad.

Not only is the defintion aspect of this game difficult, but the carveouts compound them further. In the above example, let me just go through and list the carveouts (for those now aware, carveouts are exceptions to explicity stated covenants). Skip this part if you are bored easily - the takeaway, which I will expand on further below, is that their are a lot of carveouts in these documents.

The foregoing restrictions shall not apply to indebtedness secured by Liens existing on the date of this Indenture or to any of the following:

(1) Liens on any Principal Property acquired, constructed or improved by the Company or any Restricted Subsidiary after the date of this Indenture which are created or assumed contemporaneously with such acquisition, construction or improvement, or within 180 days before or after the completion thereof, to secure or provide for the payment of all or any part of the cost of such acquisition, construction or improvement (including related expenditures capitalized for Federal income tax purposes in connection therewith) incurred after the date of this Indenture;

(2) Liens of or upon any property, shares of capital stock or Indebtedness existing at the time of acquisition thereof, whether by merger, consolidation, purchase, lease or otherwise (including Liens of or upon property, shares of capital stock or Indebtedness of a corporation existing at the time such corporation becomes a Restricted Subsidiary);

(3) Liens in favor of the Company or any Restricted Subsidiary;

(4) Liens in favor of the United States of America or any State thereof, or any department, agency or instrumentality or political subdivision of the United States of America or any State thereof or political entity affiliated therewith, or in favor of Canada, or any political subdivision thereof, to secure partial, progress, advance or other payments, or other obligations, pursuant to any contract or statute or to secure any Indebtedness incurred for the purpose of financing all or any part of the cost of acquiring, constructing or improving the property subject to such Liens (including Liens incurred in connection with pollution control, industrial revenue or similar financings);

(5) Liens on any property created, assumed or otherwise brought into existence in contemplation of the sale or other disposition of the underlying property, whether directly or indirectly, by way of share disposition or otherwise; provided that 180 days from the creation of such Liens the Company must have disposed of such property and any Indebtedness secured by such Liens shall be without recourse to the Company or any Subsidiary;

(6) Liens imposed by law, such as mechanics’, workmen’s, repairmen’s, materialmen’s, carriers’, warehousemen’s, vendors’ or other similar liens arising in the ordinary course of business, or governmental (federal, state or municipal) liens arising out of contracts for the sale of products or services by the Company or any Restricted Subsidiary, or deposits or pledges to obtain the release of any of the foregoing;

(7) pledges or deposits under workmen’s compensation laws or similar legislation and Liens of judgments thereunder which are not currently dischargeable, or good faith deposits in connection with bids, tenders, contracts (other than for the payment of money) or leases to which the Company or any Restricted Subsidiary is a party, or deposits to secure public or statutory obligations of the Company or any Restricted Subsidiary, or deposits in connection with obtaining or maintaining self-insurance or to obtain the benefits of any law, regulation or arrangement pertaining to unemployment insurance, old age pensions, social security or similar matters, or deposits of cash or obligations of the United States of America to secure surety, appeal or customs bonds to which the Company or any Restricted Subsidiary is a party, or deposits in litigation or other proceedings such as, but not limited to, interpleader proceedings;

(8) Liens created by or resulting from any litigation or other proceeding which is being contested in good faith by appropriate proceedings, including Liens arising out of judgments or awards against the Company or any Restricted Subsidiary with respect to which the Company or such Restricted Subsidiary is in good faith prosecuting an appeal or proceedings for review; or Liens incurred by the Company or any Restricted Subsidiary for the purpose of obtaining a stay or discharge in the course of any litigation or other proceeding to which the Company or such Restricted Subsidiary is a party;

(9) Liens for taxes or assessments or governmental charges or levies not yet due or delinquent, or which can thereafter be paid without penalty, or which are being contested in good faith by appropriate proceedings;

(10) Liens consisting of easements, rights-of-way, zoning restrictions, restrictions on the use of real property, and defects and irregularities in the title thereto, landlords’ liens and other similar liens and encumbrances none of which interfere materially with the use of the property covered thereby in the ordinary course of the business of the Company or such Restricted Subsidiary and which do not, in the opinion of the Company, materially detract from the value of such properties; or

(11) any extension, renewal or replacement (or successive extensions, renewals or replacements), as a whole or in part, of any Lien existing on the date of this Indenture or of any Lien referred to in the foregoing clauses (1), (2) or (5) to (10), inclusive; provided, that (i) such extension, renewal or replacement Lien shall be limited to all or a part of the same property, shares of stock or Indebtedness that secured the Lien extended, renewed or replaced (plus improvements on such property) and (ii) the Indebtedness secured by such Lien at such time is not increased.

Notwithstanding the foregoing, the Company and its Restricted Subsidiaries, or any of them, may incur, issue, assume or guarantee Indebtedness secured by Liens without equally and ratably securing the Securities of each series then Outstanding, provided, that at the time of such incurrence, issuance, assumption or guarantee of Indebtedness, after giving effect thereto and to the retirement of any Indebtedness which is concurrently being retired, the sum of (i) the aggregate amount of all outstanding Indebtedness secured by Liens which could not have been incurred, issued, assumed or guaranteed by the Company or a Restricted Subsidiary without equally or ratably securing the Securities of each series then Outstanding, except for the provisions of this paragraph, plus (ii) the Attributable Value of Sale and Leaseback Transactions entered into pursuant to the penultimate paragraph of Section 1009, does not at such time exceed the greater of (x) 10% of Consolidated Capitalization of the Company or (y) $250,000,000.

That less paragraph will be the one you generally want to focus on. Let's try to break it down just a little bit. "Notwithstanding the foregoing" means if we missed it above, here it is. And if you read it closely, you can decipher that it means that we CAN secure indebtedness, and not secure the bonds, if the amount of debt secured by liens plus a possible sale leaseback does not exceed 10% of Consolidated Capitalization or $250,000,000. Then you have to go to Consolidated Capitalization and figure out that definition, and the cycle repeats itself.

Why is this all important? Companies file for banrkuptcy for a few reasons, but the main one being they run out of money. Trade wants cash up front, banks want their money back, wages need to be paid...but there just isn't any money left. Before this cycle of doom arrives, a company will look to the capital markets to raise capital, sometimes at any expense.

And that means the company is going to be look for ANY asset it can pledge to make loan to values look good in an offering document. But if you have already bought the bonds hoping to be the first or second creditor out in a bankruptcy, and the company comes in and lops on another 1 or 2 turns of secured debt, you relative position in both valuation and bargaining strength drops dramatically.

You have to understand what the company has to prime you. Because they will if things get bad and they want to stave off bankruptcy. If there is a loophole in the covenants or indenture, it is your job as an investor to find it and either avoid the bonds (or short the bonds if the negative pledge is too restrictive) or understand the risks in holding the security.

No one truly enjoys reading indentures and credit agreements. But I promise you, some distressed debt investors out there are doing it right now, looking for loopholes to get an edge.

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Distressed Investing: How to Read a Credit Agreeement?

Devoted reader Tom B sent me an INCREDIBLE overview on how to read a credit agreement. We are going to be talking about this A LOT more in coming posts. Documents are crucial when you are investing in distressed debt...Pay close attention. This is a fantastic overview...

How to Read a Credit Agreement

If you plan to invest in distressed debt instruments (loans or bonds), you need to know the terms of the debt agreements. Ultimately, the only thing that gives you a claim to an issuer’s cash flows is the contract governing the issuer - lender relationship. These contracts are where you’ll find things such as maturity, rates, covenants and events of default along with the rights you have as a creditor. So it’s vitally important to understand the terms of your debt contract.

These documents (credit agreements in the case of loans, indentures in the case of bonds) are written by lawyers and are not easy reading, but it’s essential that you parse through them to understand the terms of the transaction. Many key terms of the loan / bond are highlighted on Bloomberg, but it is always wise to check the source document.

Let’s start with a loan. The primary document to review is the credit agreement. It contains all of the information you’ll need to understand the features of the loan. If it is a secured loan, you’ll need to review the Security and Collateral Agreement to learn which assets secure your claim. You can find the loan agreement on Bloomberg or, if you don’t have access to Bloomberg, in the company’s SEC filings (it’s normally filed as an exhibit to the 10K or 10Q filed nearest to the closing of the loan). The loan agreement typically has the following sections (though not necessarily in this order – different law firms have different templates for this document). The section you’ll spend the most time with – by far - is the negative covenants section.

1. Title page. Here you’ll find info such as the closing date of the loan, name of the borrower (legal entity), and the agent banks on the loan.

2. Table of contents.

3. Recitals. This section will tell you, again, the date of closing as well as the borrower(s) and guarantor(s) of the facility. The names of the borrowers and guarantors are enormously important because they are the only entities that are required to pay you principal and interest. Sometime, the terms Borrower and Guarantor are listed without naming legal entities. Then, you’ll have to consult the Definitions section of the agreement to see who the Borrower(s) and Guarantor(s) are. Which leads us to….

4. Definitions. You’ll need this section handy as you review the rest of the document. Every capitalized term in the document is usually defined in this section. And get used to working your way through definitions. Want to know the total leverage covenant? Ah, it’s Total Debt to Consolidated EBITDA, per the negative covenants. But, how are those terms defined? Is Total Debt reduced by the amount of Cash and Cash Equivalents? And what counts as Cash and Cash Equivalents? And how about Consolidated EBITDA? It starts with Consolidated Net Income. Is that just the net income figure from the company’s income statement or are their adjustments to make (there are ALWAYS adjustments to be made). You get the idea. But a few important definitions to always review include Applicable Margin (tells you the margin of interest you’ll earn above a base rate, such as LIBOR) and Maturity Dates. If you purchase a Term Loan B, you’ll consult the Term Loan B Maturity Date definition to see when the Term Loan B matures.

5. Amount and terms of the credits. This section includes such items as the amount of the facility as well as the amount of each tranche of the facility (so if a facility has a revolving credit and a term loan, it has 2 tranches). It will also include the amortization schedule of the facility, the amount of letters of credit that are permitted to be issued and a host of other items, many of which you really won’t have to consider. However, two items that you will have to review have to do with prepayments: mandatory and voluntary. What if the company sells an asset for cash, does it have to repay the loan? Or how about if it issues equity? What if an insured plant is destroyed by a fire, do the insurance proceeds repay the loan? Or what if the company, after satisfying all of its obligations (capital expenditures, interest, taxes, etc.) has Excess Cashflow (yes, that’s another defined term)? These questions are all typically addressed in the mandatory prepayments section. Voluntary prepayments are just as you’d guess – the company has excess cash that it would like to use to repay the loan. How can the company do that? Does it have to pay the loan back at par? Or maybe at a premium to par, like 101 in the first year of the agreement? All of this is found in the voluntary prepayments section.

6. Representations and warranties. These are a list of items that the Borrower and Guarantor state are true as of a certain date (items such as there are no material legal or environmental issues not previously disclosed to the lenders, etc.). Typically, you won’t spend a lot of time here.

7. Conditions. These are the conditions that allow the borrower to use the facility. There are usually two sets of conditions – conditions on the initial closing date and then each subsequent borrowing (for example, each revolving credit borrowing would be subject to meeting the conditions). The overriding principle here is that the borrower must be in compliance with the terms of the agreement each time it borrows. Again, not a place you’ll likely spend a ton of time.

8. Affirmative covenants. These are things the borrower must do to remain in compliance with the agreement. These include payment of principal and interest when do, delivery of financial statements within a certain amount of days after a quarter/ year end. You’ll look here to know when you must receive financial information, when the company is required to provide budgets, etc.

9. Negative covenants. This is the section you’ll spend the most time reading. It contains all of the things a Borrower CANNOT do. The big items include prohibitions on debt incurrence, prohibitions on lien incurrence, prohibitions on restricted payments (payments to junior capital providers such as dividends or share repurchases), limitations on investments and limitations on capital expenditures. A typical covenant will state that the borrower cannot incur, for example, any debt other than the debt outstanding at close SUBJECT TO the exceptions that follow. It’s the exceptions you need to know well. Can a borrower increase the amount of secured debt (thus diluting your claim on collateral)? Or can it raise an unlimited amount of unsecured debt? There are many other important issues addressed in this section. You’ll need to read each covenant carefully and have the definitions section handy, as you’ll be referring to it very frequently. I’d say that I spend 80% of the time reviewing a credit agreement on the negative covenants. A thorough discussion of negative covenants would be an entirely separate post.

10. Financial covenants. This is a section in the negative covenants, but it’s so important I’m discussing it separately. Historically, you could expect to find, at a minimum, a leverage covenant and an interest coverage covenant in most loan agreements. As the credit markets peaked in 2006 and early 2007, a good number of agreements were struck without maintenance covenants. Instead, they had incurrence covenants (for example, an issuer could issue debt provided they were in compliance with a 2.0x interest coverage ratio pro forma for the issuance). Complicating matters further, some agreements had maintenance covenants that applied only to the revolving credit facility and not the term loan. If that wasn’t bad enough, the revolver covenants only were operative if the company borrowed under the facility. So read the covenant carefully, including the preamble to the covenant. Don’t simply go straight to the table listing the relevant ratios. And, again, you’ll need the definitions section handy to accurately calculate the components of each ratio. A further note – another feature you’ll find in a number of 2006 and 2007 agreements is something called an Equity Cure. This is a provision that allows a financial sponsor to inject an amount of equity into the company to “cure” a financial ratio default. For example, if the company needed an extra $5 million of EBITDA to be in compliance with its leverage ratio, a sponsor would have the right (but not the obligation) to inject $5 million of equity and have that count as EBITDA for that quarter as well as the subsequent 3 quarters. Why is equity counted the same as cash flow from the company’s business? Good question. But things did get pretty silly in the loan market for quite some time.

11. Events of Default. Ok, here are the things that cause the company to be in default under the agreement. Non-compliance with negative or affirmative covenants, for example, or failure to pay interest or principal. Pay close attention to the cure periods. For example, a failure to pay principal when due is an immediate event of default, but there may be a period of days where the company can make an interest payment after it was due and still be in compliance (this would be the cure period).

12. The rest of the sections are fairly boilerplate and you’ll likely not spend much time reviewing them. They include a description of the role of the agent banks (as well as circumstances where a bank might be in default under the agreement) and other notices / miscellaneous items. These are not normally relevant to distressed situations.

Of course, this is intended to be a high level guide to reviewing a loan agreement. If you are going to invest in a distressed situation, it’s advisable to have a lawyer review the document as well. But this should give you a high-level roadmap to reading a credit agreement.

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Distressed Investing Concept

It has been too long since we wrote a lengthy post on a particular distressed debt investing concept for some of our newer readers. As most types of investing, distressed debt investing has some certain intricacies that morph from situation to situation. One action by a high yield issuer might portend something completely different from the next high yield issuer. If it were the case that doing a certain action, meant XYZ was going to happen, it would be mechanical and more than likely boring. What makes it interesting (and my opinion, damn near fascinating) is making the educated guesses, placing your bets, and making money in the long term.

It was reported late last week, that a favorite company in the distressed debt world, drew down the entirety of its revolver. Now, I cannot confirm nor deny this. I am just reporting what has already been reported. On the news, the bank debt rallied 4 or 5 points. Why would this be you ask?

To start, and for those that are experienced, please skip ahead, a revolving credit facility is a bank debt instrument whereas the company can draw down, like a credit card, on a revolving basis. Sometimes this revolving credit facility is secured, and sometimes, in many investment grade cases, it is unsecured. Sometimes a revolver has limitations based on a borrowing base. For example, a certain borrowing base may be 80% of Accouts Receivables and 50% of Inventory. If company ABC has $100M of AR and $100M of Inventory, they could only draw down $130M of their revolver. This mechanism protects banks in the event of a credit default.

A revolver is generally used for seasonal liquidity. If a certain company builds inventory in the first two quarters of the year, it may use its revolver to fund those working capital purposes. Then in the final two quarters of the year it will pay down the revolving credit facility and the process repeats itself.

Now banks don't offer this instrument for free. There is something called a ticking fee that is attached to the revolver. It is generally a fairly nominal amount...call it LIBOR + 25 bps on all unused committments. It is very very easy money for the banks. And the amount that is borrowed, well that is like any old instrument, paying an interest rate genearlly based on LIBOR.

Generally speaking, and this is not solely to distressed and high yield issuers, liquidity comes from two sources: 1) Cash on hand and 2) The Revolving Credit Facility. Most companies need a certain amount of cash on hand to run the business. This issue is further complicated when you take into account foreign subsidiaries that need their own cash to run, but at the same time do not want to repatriate cash back to the United States in order to avoid taxes. A crucial component in fundamental analysis is figuring how much cash a company needs, both domestically and internationally, to fully function. When a company is low on cash they may stretch payables or not build inventory - both techniques that cannot be carried into perpetuity.

Now that we understand revolving credit facilities, why on earth would bank debt increase when a revolver was drawn? Think about it, 9 times out of 10, term loans and revolving credit facilities are pari passu. And if they are not the only difference is the security granted. Oftentimes, the revolving credit facility will have a first lien (claim) on the working capital and a second lien on the PP&E. In this example, the term loan will have a first lien on the PP&E and a second lien on the working capital. So assuming this revolver in question is pari, with a larger denominator and theoretically the same numerator (recovery = value / debt outstanding), why did the bank debt trade higher?

Investing is a game of probabilities. Charlie Munger and Warren Buffett both refer to it as a pari-mutual betting system. It is basically a horsetrack. You are given odds (price), you calculate odds (your expectations), and you compare the two. If I am 50% sure I am getting 100 on a certain deal, and 50% sure I am getting 0 on a deal, the expected value is 50. If the market was pricing this deal at 40, well theoretically I should take this bet. Me personally though, there really is no margin of safety there. If the market was pricing this thing at 20 though, then I'd get excited.

In the aforementioned example, there are a few distinct possibilites that could occur. And in each of those possibilities, there is a distinct payoff to the various stakeholders. If the business survives, the returns to bank debt are decent. If the business goes Chapter, and the bank debt gets the equity, and the re-org is fairly smooth, then the bank debt could make a killing. Many different paths with many different payoffs. Sometimes it is easier to narrow it down to 3 or 4 outcomes.

With the drawing down of a revolver, what is a company, more often than now, telling us. They are telling us they need liquidity. What is very interesting though about revolving credit facilities, and the covenants that govern them is such: If a company has an inkling that business will be weak in a few quarters, and that they might not be in compliance with their covenants at that time, then they should draw the revolver (liquidity) now, just in case. The banks have agreed to lend to them if they are in compliance, and at this point in time they are. Having liquidity is far superior from having none. It gives you more of a lifeline...but really, the writing is on the wall at that point, unless some miracle of a business turnaround manifests.

So, with the likelihood of a re-organization increased, the potential payoffs to various constiuents also changes. The chance of paying junior creditors interest for a substantial amount of time is decreased, and hence that value flows to the senior creditors. So that is the first reason. Second, uncertainty is reduced. Markets, whatever you are trading, hates uncertainty. Why? Dispersion of expected value makes making sensible and reasonable guesses far more difficult. Third, and this is specific to investing in bank debt, specifically control situations, you will get your hands on the wheel faster. As a passive investor, it is like riding in the passenger seat of a runaway vehicle. Now the time to take control is closer at hand, hence upping the probability (at least we all hope) of a positive outcome.

Now of course, there are certain intracies to this specific case. There will always be intracies. In future posts we are going to talk about some more public ones. I do expect that more revolving credit facilities will be drawn in the coming years as the wall of maturities begins to crest (yes, some management teams even use their revolver to pay off subordinated creditors). And that will give us more opportunities to deploy capital in distressed debt investing situations...our favorite.

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