Exit Facilities in Bankruptcy

When a company is in the process of planning its bankruptcy exit, discussions on how the company will raise capital to fund administrative and DIP claims (among many others) begin to be heard in the market. Will the company do a bond offering? What about a rights offering? All this will be stipulated in a company's disclosure statement and bankruptcy plan.

One thing for certain though: Debtors want to raise the cheapest, least restrictive debt that its creditors will allow. And we are seeing a lot of that in the high yield and leveraged loan primary markets: Smurfit Stone, Six Flags, and Reader's Digest are a few of the more topical examples.

What is interesting to me: How cheap these financings are actually coming to market. Now I know bankruptcy is to be a cathartic process...but can one really justify an exit term loan with only incurrence based covenants? Or term loans with 7-8% rate when the DIP came at 13%?

This is all well and good for the debtors. They get cheap financing, with lenient covenants (to say the least), that is generally locked in for at least a 5 year term. The problem though: A lot of time potential lenders are looking at the disclosure statement's projections and taking them at face value. Let's look at Reader's Digest's projections (from their disclosure statement):

Now, if you can't read that, here is what you need to know:

Cash EBITDA grows from FY 2011 $184.3M to $198.8M in FY2014. Maybe I am mistaken (and I haven't read the roadshow or offering docs on this particular new deal), but I think potential bond investors in the new RDA deal (or any exit deal for that matter) may be using this cash flow to ascertain leverage metrics and free cash flow potential through the life of the new bond issue.

This disclaimer comes with the projections:

THE PROJECTIONS HAVE BEEN PREPARED EXCLUSIVELY BY THE DEBTORS, WITH ASSISTANCE OF ALIXPARTNERS. THESE PROJECTIONS, WHILE PRESENTED WITH NUMERICAL SPECIFICITY, ARE NECESSARILY BASED ON A VARIETY OF ESTIMATES AND ASSUMPTIONS WHICH, THOUGH CONSIDERED REASONABLE BY MANAGEMENT AT THE TIME AND TO THE BEST OF THEIR KNOWLEDGE, MAY NOT BE REALIZED, AND ARE INHERENTLY SUBJECT TO SIGNIFICANT BUSINESS, ECONOMIC AND COMPETITIVE UNCERTAINTIES AND CONTINGENCIES, MANY OF WHICH ARE BEYOND THE DEBTORS’ CONTROL. THE DEBTORS CAUTION THAT NO REPRESENTATIONS CAN BE MADE AS TO THE REORGANIZED DEBTORS’ ABILITY TO ACHIEVE THE PROJECTED RESULTS. SOME ASSUMPTIONS INEVITABLY WILL NOT MATERIALIZE, AND EVENTS AND CIRCUMSTANCES OCCURRING SUBSEQUENT TO THE DATE ON WHICH THESE PROJECTIONS WERE PREPARED MAY BE DIFFERENT FROM THOSE ASSUMED OR MAY BE UNANTICIPATED, AND THUS MAY AFFECT FINANCIAL RESULTS IN A MATERIAL AND POSSIBLY ADVERSE MANNER. THE PROJECTIONS, THEREFORE, MAY NOT BE RELIED UPON AS A GUARANTY OR OTHER ASSURANCE OF THE ACTUAL RESULTS THAT WILL OCCUR.

And yes it is in "All Caps" in the disclosure statement. And what about the Management Equity Plan:

Management Equity Plan. The Plan provides that the New Board will grant equity awards in the form of restricted stock, options and/or warrants for 7.5% of the New Common Stock (on a fully diluted basis) to continuing employees and directors of the Reorganized Debtors; provided that such equity grants will not include more than 2.5% in the form of restricted New Common Stock.

Now the specifications on what/when/how these options will be awarded has yet to be determined. But remember, we like to think about incentives here...what would be the incentives for showing an optimistic plan? (Note: I have no idea if RDA's cash flow will grow over the foreseeable future...I am just using them as an example).

Bottom line: It helps with emergence. It is much easier raising capital for a company that is growing versus a company that is not. Therefore, if projections do not turn out to be as rosy as defined in the disclosure statement, who gets hurt: The new lenders of course. Management has their equity (probably more than they owned PRIOR to the bankruptcy) and the company is out of bankruptcy. But if events begin to unfold that do not mesh with what was projected, someone is left holding the bag.

So when you are seeing all these new exit facilities come to market (and I am hearing there are A LOT in the pipeline), remember these disclosure statement projections can sometimes be clouded by the various players incentives in the bankruptcy case. Go over the assumptions with a fine toothed comb and run scenarios where you think management's assumptions on gross margins, or subscribers, or unit costs are different from your own: On that basis, and that basis alone should you be lending you and your investor's hard earned capital to companies emerging from bankruptcy.

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Distressed Debt Hedge Fund Manager Commentary

A few months ago, we interviewed hedge fund manager Peter Lupoff, who is the founder of Tiburon Capital Management. Peter is thoughtful in his analysis and in my opinion, one of the best emerging event-driven hedge fund managers out there right now. Given where valuations are in both the credit and equity markets, allocating capital to those managers that can profit in both up and down markets (versus being long beta) seem like a winning strategy to me.

Peter sent me a letter he recently penned to investors regarding "Confirmation Bias" in analyzing investment opportunities. In the past, we have constantly hammered the point that searching out opinions that go CONTRARY to your perceived notions is a key ingredient for success in producing out sized risk adjusted returns. The letter is a fantastic read. I hope you enjoy:

Tiburon Capital Management

Shark Bites Volume 1 Article 1 November, 2009

Risk: Confirmation Bias and the Onset of Blindness as We Develop “Clarity”

As we know, there are known knowns. There are things we know we know. We also know There are known unknowns. That is to say We know there are some things We do not know. But there are also unknown unknowns, The ones we don't know We don't know.

—Donald Rumsfeld, Feb. 12, 2002, Department of Defense news briefing

Who knew that Donald Rumsfeld was such an adept Risk Manager? The point is well taken. With regard to our investments, as you likely know, every trade idea at Tiburon is looked at through the lens of our Five Pronged Methodology. This is the linchpin, in our view, of a scalable business, creating peer-beating returns with low downside deviation. Nonetheless, every trade idea has risk exogenous to the trade. That is, there are at least two critical, broad risks to consider: 1) There are the risks we contemplate and that we seek and receive compensation for as part of the risk/reward assessment. For us, this is the risk of the occurrence of our foreseen Revaluation Catalyst(s) – that/those event(s) that will move securities we may be long or short, in a step-function change to fair value. 2) There are those risks we identify to be outside of the trade thesis, i.e., exogenous to the trade thesis. Tiburon professionals and risk management (internal and external) will conceive the most correlated and effective hedges to wring this risk out. However, as Donald Rumsfeld would point out, we’ve then contemplated, probability weighted and where effective and desirable, hedged out the known risks - what about the risks we don’t know that we don’t know?

The Dangers of Bogus Math and Observances that Seem “Empirical”

Not only are there risks we don’t know we don’t know, but we routinely gather data deemed empirical that reinforce our beliefs, eventually blinding us to, or lessening our sense of the probabilities of risk. I will pull another reference out in demonstrating this concept of risks we don’t know that we don’t know (at the risk of angering some of my quant and academic friends).

An acquaintance of mine, Nassim Taleb, the writer of “The Black Swan” puts it this way:

I start with my old crusade against "quants" (people like me who do mathematical work in finance), economists, and bank risk managers, my prime perpetrators of iatrogenic risks (the healer killing the patient). Why iatrogenic risks? Because, not only have economists been unable to prove that their models work, but no one managed to prove that the use of a model that does not work is neutral, that it does not increase blind risk taking, hence the accumulation of hidden risks.

The More Clarity the Less Vision

Investment professionals will spend endless hours tinkering with models, listening to company conference calls, doing channel checks, meeting management, competitors, etc. Few, however can ring Confirmation Bias out of their work. Like the turkey, actively chronicling its daily access to housing and food from altruistic humans, most investment professionals have a tendency to develop an impartial view and then actively seek data that support their supposition. Confirmation Bias, the human trait of seeking and interpreting evidence that is partial to existing beliefs, expectation and hypothesis, is a risk of human bias that can only be wrung out of portfolio, in my view, with a rigorous and agnostic investment methodology and risk culture that actively engages in objective scenario analysis. A recent Wall Street Journal article quoted a vast psychological study that concluded that people were twice as likely to seek information that confirms what they already believe as they are to consider evidence that would question those beliefs. Do we not have some covenantal obligation to investors as a fiduciary to wring out this risk as well?

A Third Eye for More Clarity of Vision?

Absent stepping to the challenge of projecting all downside scenarios that can be concocted, we too, would be in the business of simply putting on trades and then earnestly capturing all the data that supports the trade thesis. As part of the way we think about risk at the research level, we imagine a bad outcome for the trade and then attempt to list the most compelling reasons for the trade’s failure. This is a form of projected forensics, for lack of a better way to describe it.

The Deception of a Reinforcing Market Price and the Wall Street Feedback Loop

So here we are again in late 2009 with rising asset prices, providing investors with confirmation that everything is fine and the pundits that reassure that doomsday scenarists are always early. At Tiburon, our take is “who cares”? I don’t mean to be flip on this point. Yes, we do care and work vigorously to cultivate our dynamic world view. Aren’t we supposed to make money in all markets? The point is that the portfolio is granularly conceived at the trade level. Risks exogenous are managed at the trade level. If this is done, we’ve done as well as most professional investors do. However, taking our blinders off as we systematically build the case for the investment allows us to see all data with impartiality. Defining the compelling reasons why we are wrong is part of this process. The point is to make good decisions – not to achieve consensus or arm ourselves with data to rationalize mistakes. We often talk about how conviction level about our Revaluation Catalyst shapes position sizing. This is true, but greater conviction does not create a greater probability of being right absent correcting the very human Confirmation Bias.

Peter M. Lupoff November, 2009 Tiburon Capital Management, LLC

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DDIC: Guests Admitted

I wanted to give a heads up that all guests that have requested access to the Distressed Debt Investors Club should now have access. If you do not remember your password, please visit: Distressed Debt Investors Club Forgotten Password. If you are still having problems, please contact me.

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Distressed Debt Ideas for 2010 - General Motors

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Wisdom from Seth Klarman - Part 9

We continue our long-running Seth Klarman series where we analyze Baupost's annual shareholder letters with the second half of the 2008 annual letter.

"Baupost build numerous new positions as the markets fell in 2008. While it is always tempting to try to time the market and wait for the bottom to be reached (as if it would be obvious when it arrived), such a strategy has proven over the years to be deeply flawed. Historically, little volume transacts at the bottom or on the way back up, and competition from other buyers will be much greater when the markets settle down and the economy begins to recover. Moreover, the price recovery from a bottom can be very swift. Therefore, an investor should put money to work amidst the throes of a bear market, appreciating that things will likely get worse before they get better."

A problem that many value investors complain about is buying too early. In distressed debt, transaction volumes at the bottom are nil at best. Even worse, some dealers will quote incredibly wide markets which can make buying an exercise in futility...for example: would you buy a bond when a dealer quoted you 10-30 ... you can buy at 30 or sell at 10...This was seen quite often in the months following Lehman brother's bankruptcy.

"Most of our new investments in 2008 were in deeply discounted senior corporate and residential mortgage debt. Debt instruments, because they occupy a senior position in a corporate capital structure and pay interest and principal on a contractual basis, are typically considered less risky than equities. For this reason, when corporate debt become troubled and the possibility of default rises, holders often overreact. When the promise to timely pay interest and principal is on the verge of being broken, many will urgently sell either from fear or due to restrictions in their investment charters. Enormous legal and process complexity create great uncertainty, which adds to the pressure to sell. Prices often overshoot to the downside, creating an attractive risk-return proposition, especially for those able to analytically deal with complexity.

Beyond favorable pricing, distressed debt involves multiple catalysts for the realization of underlying value. If a troubled company is able to recover, whether through operational turnaround, asset sales, or capital infusions, the contractual repayment of principal is a catalyst of full value realization. Alternatively, if the company fails to recovery, reorganization through the Chapter 11 bankruptcy process, whereby a company satisfies claims in the order of their legal hierarchy, can itself result in value realization. In bankruptcy, senior debt holders often receive cash, new debt, equity or some combination thereof, in return for their defaulted securities. Being first in line for recoveries from the corporate estate can confer a valuable margin of safety."

Many smart value investors were looking at Senior Secured debt in November and December 2008. For example, a company like Dollar General saw its bank debt trade to the mid 70s. This effectively created the company at 2x EBITDA through the senior secured bank debt. Equity Comps of the other hand, were trading 6-7x EBITDA - and with dollar general you were also getting a nice coupon stream equating to a size able IRR if the valuation discrepancy collapsed...which it did and investors earned ~40% return with minimal downside risks.

Even for those companies that filed, the ability to cease paying interest to creditors may create a windfall of cash to be distributed in reorganization. Further, we are always looking for value with a catalyst at Distressed Debt Investing, and bankruptcy is by far our favorite catalyst.

On thinking about declining security price:

"Many of the distressed debt investments we bought in 2008 declined further after our initial purchases, inducing us to buy more, as we often do, after thoroughly checking and rechecking our analysis and assumptions. Although most investors find it painful to have positions decline in price after purchase, we remained focused on the silver lining: the ability to building large positions at increasingly favorable prices. In many ways, this temporary market decline represents delayed gratification. When we buy a four-year bond with a 5% coupon at $70.7 to yield 15% to maturity and the price drops immediately to $60.0 where it now yields 20%, we have a 15.1% mark-market loss, but (assuming no new fundamental developments) now hold an even more attractively priced investment while experiencing an even better buying opportunity. A rise in the market's required yield to 25% would cause a further 14.6% price decline. Clearly, if our initial analysis was correct, these temporary price declines, as significant as they are, will be far more than offset by the eventual profitable recoveries."

An investor has to realize that a decline in price does not always equate to a decline in value. And when price declines significantly beyond the value of a business, a buying opportunity may arise.

On the government stimulus plan:

"When the government prints money to solve a problem, the result is almost always inflation. The history of paper money, back by nothing except a government's promise to pay, is that it will be debauched. Politicians are good at spending money that is not theirs; they can please all, antagonize none, by going on a spending spree while asking no one to pick up the tab. But the bill will come due and taxpayers are ultimately on the hook. National wealth cannot be created by a printing press but only be education, hard work, saving, and investment. "

Continuing...

"Over the next several years, inflation seems inevitable, along with much higher interest rates, which will surely impact the value of most investments. We have put hedges in place that we hope will protect our portfolio should such risks materialize."

I wonder what hedges he is talking about? Maybe buying calls on interest rates? But is he playing the long end or the short end of the curve? My concern in high yield, where I have been spending a lot of my time, is that even if you get your credit calls right and you find an improving story, if the curve widens 200+ basis points, you will show mediocre return.

"...James Montier, Societe Generale's market strategist, recently pointed out that when athletes were asked what went through their minds just before competing in the Beijing Olympics, the consistent response was a focus on process, not outcome. The same ought to be true for investors.

According to Montier, during periods of poor investment performance, the pressure builds to change the process to enable immediate gratification. But, so long as the process is sound, this would be a big mistake. It is so easy for one's investment process to break down. When an investment manager focuses on what a client will think rather what they themselves thing, the process is bad. When an investment manager worries about their firm's viability, about possible redemptions, about avoiding loss to the exclusion of finding legitimate opportunities, the process fails. When the manager's time horizon become overly short-term, the process is compromised. ..."

How many of us are guilty of this? You have to maintain the discipline that the Graham and Dodd approach to investing is sound and not delve into the unfamiliar when your returns lag the market. You will never be right 100% of the time. Maybe this is why Joel Greenblatt's formula works so well over the long term - people lose the discipline to keep up with it out of sheer need for immediate gratification.

Klarman then goes on to talk about the investing process at Baupost. The relevant quote I think most pertinent:

"Once we decide to invest, the work continues. Are their new developments? What additional information should we seek? Are their affordable hedges that can limit our risk? If the price falls should we increase our position? If a price rises, at what point should we start to sell and at what point should we wholly liquidate our position? If dealing with a private real estate investment, should we raise or lower rents, reposition or spruce up the asset, refinance, or offer the property for sale?

Perhaps most crucial to the success of this process is intellectual honest. Have the facts changed? Was our original judgement wrong? Are their better investment to hold? If we made a mistake, we need to recognize it and learn from it."

Two takeaways for me here: 1) They do not liquidate a position all at once but will ease out of it as the price rises 2) They believe it just as important to monitor investments as it is to find new ones. A weakness of mine is wanting to look at new situations because the more information I get the better.

He closes out the letter with a section entitled: "The Value of Not Being Sure" ... I will not reprint the whole section, but will strip out what I think is my favorite paragraph of the entire letter:

"Always remembering that we might be wrong, we must contemplate alternatives, concoct hedges, and search vigilantly for validation of our assessments. We always sell when a security's price begins to reflect full value, because we are never sure that our thesis will be precisely correct. While we typically concentrate our investment in the most compelling situations measured by reward compared to risk, we know that we can never be full certain, so we diversify. And, in the end, out uncertainty prods us to work harder and to be endlessly vigilant."

Fantastic. This concludes our reviews of Seth Klarman's shareholder letters (we will not review the 2009 letter for another 12 months). What I will do is continue the series, analyzing some of the Seth Klarman videos I have my hands on, as well as take a look at Baupost's portfolio when their various 13Fs come out.

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