Distressed Debt Case Study: Lear

Before we get to the Lear distressed debt case study, I want to let everyone know that I received their email regarding the Distressed Debt Investor Club. I am happy to say I have received approximately 50 emails already. Please, if you don't mind, spread the word! I will talk about the application process in the coming weeks.

Now on to the fun stuff: Lear. For reference, here is the docket: Lear Docket.

Lear, like many auto suppliers before it, filed for bankruptcy protection due to declining auto sales (SAAR from 15M in 2007 to projected 8M in 2009) and its higher debt load. Knowing that the writing was on the wall, Lear and its lenders/bondholders worked out a pre-packaged bankruptcy (pre-pack) to allow for emergence as soon as feasible. The longer in Chapter 11, the more the lawyers and advisors get paid. No one wants that.

Lear detailed its proposed restructuring via an 8K that can be found here: Lear Proposed Restructuring. This is by no means a final agreement. As the 8K states: "agreement in principle" so there could be changes in the future. Summarizing:

• Restructuring approximately $2.3B of bank debt and hedging claims and $1.3B of bonds.
• $500M DIP consisting of a Term Loan that matures in a year and has a 15 month extension (needed if the case goes awry). Proceeds will be used for W/C and other corporate needs. The DIP is convertible into a $500M exit facility (rolled into) that matures 3 years after a plan is approved.
• The new Lear would consist of: 1) This $500M exit facility 2) A $600M second lien 3) $500M of preferred stock 4) And stock with certain management incentives and warrants to unsecured and lenders.
• The pre-petition bank debt lenders will receive, on a pro-rata basis: i) $600M second lien, ii) $500M of preferred stock which is convertible into 26% of common stock (excluding management incentive dilution) iii) approximately 26% of common stock (excluding managment incentive dilution). Their unsecured claim would be treated in the unsecured bucket (as an aside, this is an interesting point we haven't talked about...a bank debt lender is only secured up to the point that the collateral merits. So for instance, if there is $100M of senior secured bank debt and $100M of bonds, and the company's value is only $50M...lenders would have a secured claim for $50M, and an unsecured claim for $50M which they would share with the $100M of bonds...for a total unsecured basket of $150M...confusing I know)
• In the case Lear has more than $1B of liquidity at plan confirmation, certain excess liquidity will be used to pay down preferred, second lien, and the exit (in that order, respectively)
• Trade will be paid in cash
• Senior notes and other unsecured claims are getting 46% of stock (again fully diluted outside management grants) and warrants to purchase 15% of stock.
• Equity getting wiped out.
• Management getting an incentive plan to possibly own 10% of the post-reorg stock. This is HUGE in my opinion.

The 8K also goes on to list the value of Lear at $3.054B. From Bloomberg, the median EBITDA estimate for 2010 and 2011 is $511M and $550M respectively. With $1.2B of cash on the balance sheet today, this implies an EBITDA multiple of 3.6x and 3.4x respectively. To put this in perspective, in the middle of 2008, the sell side was estimating Lear would do over $1B in EBITDA for both 2010 and 2011. Further, EBITDA in 2007 was over $1.1B Management projected to lenders that Lear would do $450M of EBITDAR in 2009.

But can we really believe them?

Let's think about this for a second. Actually better yet, let's think about the incentives for a second. You can find these incentives in the same 8K, almost all the way to the bottom.

• Number of shares: 10% of new common stock
• Upon emergence, 2.7% of new stock...SO JUST FOR EMERGING THEY ARE GETTING 2.7% of the company. The CEO gets 18.25% of this or nearly 50bps of the new company.
• The remaining incentives will be performance based...i.e. meeting certain hurdles.

Now if you are management, are you going to go out there and say "Yea. We are going to crush it in 2010" even if you are 95% certain you would? Of course not. Setting a low hurdle when equity options are at stake is par for the course. So I would wager than $450M of EBITDAR in 2010 might be a lowball. Now remember, the CEO gets 18.25% of equity awards, so at some point in the future, he could own 1.825% of Lear. As of 3/14/2009, he only owned 0.565% of Lear...a much worse Lear with a lot more leverage. I have to say he is getting a pretty sweet deal.

So, now that we have all the technicals out of the way...let's see if there is anywhere we can make money? The pre-petition bank debt is trading at 70 cents on the dollar (was as high at 78 right after the filing). Currently, Lear has $1.2B of cash on the balance sheet and $2.25B of senior secured bank debt. Now we all know this year is going to be bad. They are going to burn cash. No doubt about it. Let's just assume, for simplicity, that they burn cash to that $1B liquidity trigger...i.e. they would emerge with $500M of cash.

Before I jump into what I think the bank debt is worth, I want to point out a few interesting / salient points about Lear. Lear has been a darling of the value investment circles. I believe Monish Pabrai (at least his consensus alias) wrote it up in Value Investor Club a few years ago. Rich Pzena has talked about it at Joel Greenblatt's Columbia class as a good investment. Franlin Resource, some of the best opportunistic value investors out there, is the 3rd largest holder. What gives?

Lear's main business, seating, is a duopoly in North America (Lear #2 supplier behind Johnson Controls). Both Lear and Johnson Controls have played nice and not gone into any sort of price war and surprisingly, have pricing power with the OEMs. Same thing in Europe with Lear #3 behind JCI and Faurecia. Further, the seating business really is not that terribly capital intensive relative to some other auto supplier businesses. EBIT Margins are tight right now given auto sale volumes, but management has led a fantastic cost cutting effort, and I believe a conservative run rate would be approximately 5% with definitely lots of room for upside. 50% of business is domestic, 50% overseas. Lear's electronics business is a smaller portion of the business, about 1/5 of total revenue. I am going to value this entire business at 0. Again, let's be conservative here.

Seating revenue in the past 5 years has been:

2008: $10.7B

2007: $12.2B

2006: $11.6B

2005: $11.0B

2004: $11.3B

Remember, we said this business should do at least 5% EBIT margins. Using a low of $10B of seat sales and a high of $11B, gets us to EBIT of between $500M and $550M. D&A at seating is approximately $175M giving us EBITDA of $675-$725M. Corporate expenses should trend around $175M (run-rate) implying total EBITDA of $500-$550M, in line with the sell side, and meaningfully over management. A quick point here...look at the leverage this company has. A 1% increase in EBITDA margins = $100M incremental EBITDA. BOOYA.

Again, let's say for the sake of argument, that cash is zero at emergence. I think Lear is worth somewhere around 5.0x, given the dynamics of the business. Let's use 4.0x, 4.5x, and 5.0x on our $500 - $550M EBITDA forecasts

At 4.0x on the $500M we are coming up with $2.0B of value. At 5.0x on the $550M of EBITDA we are coming up with $2.75B of value. So for our intent and purpose, lets figure out where the range of $2.0B-$2.75B puts us.

Now, I am going to make an an assumption here that all warrants, preferred conversions, awards are granted. What I am coming up with, as mentioned before, gives management 10% of the equity, and bank debt lenders 58% of the equity. So, all in all, the bank debt lenders are getting a $600M second lien note and 58% of the equity of the company (once preferred is converted).

With our range of $2B-$2.75B we need to deduct the $500M DIP and $600M second lien, and add back $500M of cash, to get to equity value. This gives an equity range of $1.40B to $2.15B. 58% of that plus $600M of second liens gets us to a recovery value of $1.41B to $1.85B. This versus a claim of $2.25B for, wait for it, a recovery of 63 cents - 82 cents. As an aside, bond holders are getting 32% of the company, giving them a recovery of 32% of our calculated equity value of $1.4B-$2.15B or ~$450M to $688M. This versus a claim of $1.3B implying a value of 35-52 cents on the dollar (bonds are currently trading at 40).

A few things to point out. Remember, we used a conservative seating margin, gave 0 value to the electronics business, used fairly conservative multiples, burned a lot of cash, etc. We may have been too conservative. At say $700M of EBITDA at 5.0x, bank debt lenders would recover north of par (~110 to be exact). The bond holders at these levels would be bigger winners.

In all honesty, I kind of like both securities. But not just yet.

Looking at Exhibit 10.1 in the 8K Lear filed outlining its plan, we can get a sense of who the lenders are. It definitely is an interesting mix. One thing that sticks out: Lots of CLO names on that list. CLOs do not like to hold equity (no cash flow relative to their liabilities). CLOs like it when recovery is granted via other cash paying debt securities - not equity, like in Lear's case. So, what I think you will see, or are seeing now, are CLO's selling down their paper, knowing that a large portion of their recovery is coming from equity. So when would I buy this thing? I would buy the equity, after it emerges and after the CLO dump is finished. I'd then be getting a conservatively levered (~2x) autosupplier, with solid prospects, and massive operating leverage at the bottom of the cycle, at probably a better discount than I am getting today. Now if they bank debt got to say, the mid 50s, or the bonds in the low 30s, then I'd be buying this paper. When the equity is free to trade, I think I am going to put on a position (assuming the puke is done in an orderly fashion)

Of course, I may miss it if it never gets to that level. But there will be more opportunities in the future. Have to watch a lot of pitches go by before you take your swings. This will indeed be an interesting distressed debt case to follow.

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Distressed Debt Investors Club

As some of you are aware, one of the reasons for the lack of posting in the last month (despite the dearth of solid investment opportunities) is that I have been working on a side project related to the site; more specifically related to Distressed Debt. Since the information seems to be spreading (I am getting requests about it), I might as well go ahead and discuss it in a public forum.

Many of us are either Value Investor Club Members or SumZero members (and some both). Both sites are incredible. That being said, they both have their advantages and disadvantages. But overall, they are fantastic resources.

In my opinion though, a member contributed site, in a similar vein to VIC or SumZero, focused on credit, distressed, and fixed income special situation opportunities (make whole take-outs, CDS arbitrage, fixed income arb, etc) would be incredibly beneficial to its members.

So that is what I have been working on. And here is a little FAQ I put together:

Is that all you can tell us? - No. Here are a few more salient points:

• The site will be set up very similar to VIC. 250 members with real time access, guests will have read-only access on a 60 day delay window. Members will be asked to contribute, like VIC, 2 credit related posts per year. Again like VIC, but unlike SumZero, (and because I love anonymity), we will be using aliases instead of our real names - so members do not have to worry about posting their fund information or their real identities. There will be more details in the coming months.

How can I become a member? - Potential members will be asked to write a 2-3 page write up on a credit or investment opportunity of their choosing. There will be no template for this. I hate templates and so should you. Myself, and two of my colleagues will go through each one, offer questions to each applicant, and then take it from there. In the next month or two, there will be more and more posts about all this, which leads us too...

When is this launching? - 3Q 2009. Exact date depending on beta tests and all that good stuff. Therefore, hold off on sending me anything until I ask =]

I am already a member of VIC and SumZero. Why do I need another community of hedgies talking their book? - Good question. As I mentioned earlier, this site will be credit focused (not to say that equity ideas will be forbidden...but in general I hope we are talking credit / fixed income special sits 90% of the time). I would like us to carve out a little niche here and make lots of money. Plus, given how small the site will be (I am talking about members here), it should be an incredible networking opportunity.

Further, on launching, the site will have 250 ideas (the applications) ready for all members to pounce on. If you can't find one or two ideas out of 250 to make a killing on...well you sir, are a better man that I.

Can anyone join? Theoretically yes. As long as you add LOTS of value. That being said, I have to think that their will be a heavy weighting of credit / fixed income professionals in the mix.

Where can I find out more information? You can email me or leave a comment. And stay tuned for future posts.

I'm hoping this distressed debt boondoggle gets off the ground in a timely fashion. Support, hate, or praise can be left via comments.

Thanks -

Hunter

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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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How to Get a Hedge Fund Job

As some of you have discovered, I started a new blog to help answer the question I get more often than any other: "How do I get a hedge fund job?" I doubt there will be more than 10 or 15 posts ever on the blog so do not get too jealous. Any ways, I just threw up a post that I think will be an interest to some readers: A listing of Julian Robertson's Tiger Cubs...at least as many as me and a few friends, with too much time on our hands, could could up. Enjoy!

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Distressed Investing News

So let's say you are a distressed debt investor already, where do you go for distressed investing news? Admittedly, it took me a long time to figure out how to best stay on top of all the happenings in the distressed debt community (outside of working the phones and talking to advisers).

So here is just a sample of what I do to make sure I am in the know on the various stories coming across the tape in relation to distressed investing news.

1. I set up my Bloomberg Launchpad with lots of news panels: Now, I know not all of us are fortunate enough to have a Bloomberg. But if you do, for reference, I currently have a number of News Panels running: Forbearance Agreements / Credit Waivers, High Yield Bonds, AmendedLoans, Syndicated Loans, Distressed Corporate Bonds to name just a few. I also have one for my main monitor which shows me all new stories related to the equity and bond tickers that we own, and all the comps for the companies.
2. In relation to #1 above, I always read Bill Rochelle's column on Bloomberg. I have done this every morning for over 3 years now. To access the article type in: NSE ROCHELLE ... now if you do not have a Bloomberg, you can access the stories at the Bloomberg Bankruptcy News page
3. Like most people that trade / invest in corporate bonds, I get approximately 3,000 runs from brokers and dealers. A lot of time it is just noise, but every now and then something will come across the tape that adds value. Therefore, I am checking that screen intermittently. For example, on the day before Lear filed for bankruptcy, the bank debt was up 7 point on no news. Obviously something was happening behind the scenes. The equity market and the corporate market weren't really responding. If I had any balls, I would of shorted the equity (at 0.50)...and be up 50% in a day and a half.
4. I read CreditSights and BondHub research pretty much every day. Now I know some people are going to moan this: "Who cares what the sell side thinks" ... well a lot of idiots do, and in my experience, idiots are pricing the market. If you do your research, and you are coming up with an EBITDA number that is materially lower than the forecasts or published research numbers, well that is a potential short candidate. In terms of news though, every now and then there might be something that missed our radar screen and an analyst will talk about it...there could (or could not) be an investment opportunity there.
5. I check Pacer and various Court Dockets so many times it makes me sick: No seriously. It is such a tedious process. If anyone knows a way to automate this or wants to start a company that automates this with me, let me know. This is important because rulings move markets, new information from court filings move markets, you want to be ahead of the news.
6. I know when my companies are reporting, what the consensus is, and what to do if there is any crazy price action. I know this sounds more traderesque, but if you were forecasting $100M of EBITDA in the quarter, and the company comes out with $10M what are you going to do? These are important questions in illiquid markets like the corporate and levered loan markets.

So those are just some of my methods to stay on top of distressed investing news. There probably is a few more ways people stay in the know of what is going on in this nutty world. If you know of any more distressed investing news resources, please post a comment and share. Happy 4th!

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