Distressed Debt Book Review - The Predictioneer's Game

As many of you know, I have written about how important it is to look at incentives when predicting what may happen, or what the probability something may happen, in certain distressed debt and high yield investing situations. It is my belief, that generally speaking, people act in their own best interest. Whether it be a management team that sides with a certain creditor plan because their upside will be greater, or a group of creditors that may block a debt exchange to trigger the default provision in a credit default swap, it is vitally important to look who is getting what spoil when deciding how to allocate your own capital. Few books discuss the implication for motivated self interests and how one can use those same self interests to make decisions about the future. I just finished reading one...and frankly...It was fascinating...

The Predictioneer's Game by Bruce Bueno de Mesquita talks about the use of game theory to predict the future course of events. If you have not heard of the Bueno de Mesquita, there have been a number of articles written about him in the past. He run's a consulting business (who's number one client apparently is the CIA) which predicts the unfolding of future evens using game theory. From the Book Description:

Bruce Bueno de Mesquita is a master of game theory, which is a fancy label for a simple idea: People compete, and they always do what they think is in their own best interest. Bueno de Mesquita uses game theory and its insights into human behavior to predict and even engineer political, financial, and personal events. His forecasts, which have been employed by everyone from the CIA to major business firms, have an amazing 90 percent accuracy rate, and in this dazzling and revelatory book he shares his startling methods and lets you play along in a range of high-stakes negotiations and conflicts.

For me, the political discussion in the book was interesting. But as noted above, I care more about how rational (maybe sometimes irrational) actors act in the finance world and how I can profit from these opportunities. Many of us have read about Game Theory, or learned about it in our Econ classes far too long ago - this bring a real world, tangible discussion to the mix which merits everyone's attention.

After reading this book will you be able to lay claim on a 90% hit ratio on prediction on which company is getting acquired or which company is next going to file...No. Definitely not. But it will begin to show you, that when you break things down, predicting how certain situations or cases will play out can become blindingly obvious.

The book is a fast, quick read. There is some promotional aspect to the book (he runs a consulting business and hence wants to show off his predicting abilities). Nonetheless, I think this text is an essential addition to the enterprising investor's library.

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Wisdom from Seth Klarman - Part 8

This is our 8th edition of Wisdom from Seth Klarman. In this edition, we will analyze the 2008 Baupost Annual letter. This, like other parts of the Seth Klarman series, will be split into two posts.

If anyone ever asks you why the "Great Recession" transpired:

"The implosion of the subprime mortgage market in 2007 let to losses that ultimately precipitated a collapse of financial institutions and markets and nearly the system itself. The 2008 financial market sell-off accelerated into a panic after September's Lehman Brothers bankruptcy filing, as no one could figure out who was, or would remain solvent. Selling by financial institutions, desperate to rein in their balance sheets, put sustained pressure on securities prices. Strategies that relied on leverage were the first to fail as the downdraft triggered margin calls. Dismal investment performance drove redemptions from equity and debt funds alike, necessitating further selling, and thereby creating a downward spiral that overwhelmed investment fundamentals. With the exception of mispricings that have ensued, this is actually value heaven; it just feels like value hell."

Incredible right? You can take that one to the bank.

"In today's unforgiving environment, buying anything has become so punishing that few (we are one of the few) want to do it any more. Numerous competitors have gone into hibernation or become extinct, victims of the market selloff, investor redemptions, or margin calls. Even those with capital, unsure of their staying power, seem unwilling to invest it. Holding cash, which would have been a far better idea had people thought of it when prices were at their highs, is now in vogue."

It is so interesting to me. So many of the great investors (Klarman, Buffett, Icahn) all espouse the benefits of holding cash. Many investors (whether that be of the advisory or even the corporate side) look up to these people. But nonetheless, so few are committed to holding cash as a strategic asset. Whether it be the "institutional imperative" to always be fully invested or the fact that it is difficult to defend to stakeholders being only 50-60% long when the market is going up, it seems like so few people feel comfortable holding excess cash. Think of all the corporations that bought back stock in 2006 and 2007, only to see their stock prices down 50-80% ... think of deploying all that capital at early 2009 levels - now that is a smart capital allocation choice.

"It is easy for the volatility of one's thinking to match the volatility of prevailing conditions. Time horizons have shorted even more than usual, to the point where the market's 4:00 p.m. close seems to many like a long-term commitment. To maintain a truly long-term view, investors must be willing to experience short-term losses; without the possibility of near-term pain, there can be no long-term gain. The ability to remain an investor (and not become a day-trader or bystander) confers an almost unprecedented advantage in this environment. The investor's problem is that this perspective will seem a curse rather than a blessing until the selloff ends and some semblance of stability is restored."

I remember the "dark days" of late 2008, when literally a bond would be quoted down 20 or 30 points on no news. Nothing. Everyone always blamed Lehman's prop desk from blowing out a position. But really - there were no buyers. So few of us were pounding the table saying things like: "Listen - I know the markets are trading like the world is coming to an end - But if I can create HCA through the bank debt at at 2x EBITDA, the upside-downside on that trade is out of this world and one we may never see again in our life times."

"Warren Buffett has said - and other have endlessly repeated - that you can't tell who is swimming naked until after the tide goes out. This turns out to be only partially true. The tide has receded, and most portfolios are down. But not all declines are equal. Some investors have lost money and locked in those losses by going to cash. Some have made investments in failed or failing banks, brokers, and homebuilders, or toxic subprime mortgage securities; these losses are largely permanent and irreversible. But the investment baby has been thrown out with the bathwater, and some who invested wisely aren't naked, it just seems that way. Buying early on the way down looks a great deal like being wrong, but it isn't. It turns out you won't be able to accurately tell who's been swimming naked until after the time comes back in.

As Benjamin Graham and David Dodd taught us, the financial markets are manic and best thought of as an erratic counterparty with whom to transact, rather than as an arbiter of the immediate accuracy of one's investment judgement. There are days when the market will likely overpay for what you own, and other days when it will offer you securities at a great discount from underlying value. If you look to 'Mr. Market' for advice, or if you imbue him with wisdom, you are destined to fail. But if you look to Mr. Market for opportunity, if you attempt to take advantage of his emotional extremes, then you are very likely to succeed over time. If you see stocks as blips on a ticker tape, you will be led astray. But if you regard stocks as fractional interests in businesses, you will maintain proper perspective. This necessary clarity of thought is particularly important in times of extreme market fluctuations."

There folks, are two of the greatest paragraphs on investing that I have ever read. Klarman has written extensively on the problem of "catching a falling knife" in investing...i.e value investors tend to buy early. But in the end, we have to stick by two truths: 1) None of us can consistently call the bottom 2) Buying a dollar for 50 cent as opposed to buying a dollar at 30 cents, is still better than buying a dollar for 90 cents. If we come from a position of strength (with cash and with capital that will not flee at every rocking of the boat), and practice the tenets of value investing, we should come out on top.

"Most investments - illiquid private transactions, but also publicly traded stocks and bonds - are like roach motels, easier to get into that out of. When you make an investment you give up liquidity and valuation certainty of holding cash. You do so, presumably, to earn a higher return while accepting the risks of diminished liquidity, price volatility, and fundamental value impairment. To be successful, you must maintain the thought process articulated by Graham. When a seemingly attractive investment suddenly retreats in market price in the absence of adverse fundamental development, you must have the psychological makeup t see it as more, not less attractive. If you have either investment constraints or flighty capital which makes it impossible for you to favor an investment more after its price falls, then you shouldn't be investing at all."

Theoretically this is fantastic. But most of us do not have a 25+ year track record to lock investors in. I have a theory on the best way to accomplish this and am working on some practical applications for it - more detail in the future.

Later in the week, will discuss more of the 2008 Baupost annual letter. It really provides some fantastic investing lessons.

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Distressed Debt Investing on Linked In

I set up a Distressed Debt Investing Group on Linked In. I will post interesting distressed debt articles I come across throughout the week on the group website and hope to foster some community discussion and networking opportunities.

If you would like to join, please visit this link:

Distressed Debt Investing on Linked In.

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2009 - What a Year for Distressed Debt!

What a year for distressed debt. By every metric known to the credit investing community, 2009 was a blockbuster year:

• CCC index up over 100%
• Year-to-date inflows of HY funds over $20B
• LSTA Leveraged Loan Index up 52%
• Pilgrims Pride Sub Notes: up 105 points to 111 (yes, you read that right)
• Spansion Senior Notes: up 101 points to 108
• Bon-Ton Senior Notes: up 80 points to 92
• Post-re org stocks, like Dana or Solutia, that were widely held by various distressed funds up 5-10x from their lows.

And it continues - ResCap bonds are up 20 points in the last few days.

What I think is the most telling statistic: CDS Auction Settlement Prices and where bonds are trading today...

As a quick primer: When there is a credit default swap (CDS) outstanding on an entity, and a default occurs, Markit will run an auction to determine the settlement price for an outstanding CDS contract. If you have bought protection on an entity, you will be paid par less the settlement price (i.e. if the settlement price is 10, you would receive 90 points on your notional). And if you are a seller of protection, you would pay up those same points.

Now, why do I think this is important? I believe filing of bankruptcy causes certain lenders and investors in high yield and leveraged loans to sell their holdings for "uneconomic" reasons. In other words, forced selling. This may be anything from CLOs that need to empty some baskets to insurance companies that bought paper at par in the primary, and cannot own defaulted securities. In that, I would think that while the event of bankruptcy may not be the "low" on a particular security, many times it will be an event that forces some sellers out and provides a catalyst for future capital appreciation.

Let's look at the data. Using Markit's incredible site, which details date and settlement price for various auctions both in CDS and LCDS land (I am going to solely discuss CDS this time around), I can get a sense for where a security is trading when a default occurs. There are some limitations to this of course (i.e. the bond may not of been trading exactly where the auction price went off for hedging or unique reasons), but it will be pretty close. I have listed the company name, auction date, auction settlement price, and the year end bond price (ball parked according to dealer runs and TRACE) for the on-the-run bond in the capital structure. Going in chronological order from Markit's site (note - I have not included all bonds on the list, specifically predominantly European issuers, CIT [too recent], and a few other bonds [most are up dramatically as well]):

Yes. You read that right as well.

379% percent return average return. (306% if you exclude the Tribune bonds).

Will this strategy work in the coming year? I think it will, but I doubt to the tune of 2009. 2009 was such a great year for distressed debt and debt investing, but the math alone makes it hard to justify another return like this. Here's to hoping its one-half, or even a quarter, or even a tenth of 2009's return...

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Distressed Debt Research - Tronox

Every few months, I am going to take a recent submission from the Distressed Debt Investors Club and post it to the blog. This week, Tronox, a distressed debt situation authored by member jnahas, will be presented. This allows readers to see the quality / type of ideas being posted to the site which will help you decide if you would like to apply as a member or a guest. Currently, there are over 200 guest membership requests for the site - I have not approved them yet as we add some new and exciting functionality - member requests are being processed as they come in (we are up to 75 high caliber members posting a number of ideas each week). I will write an "Inside Look" post on the DDIC later on in the week for all that are curious.

One quick point before posting this case: The Distressed Debt Investors Club allows users to upload attachments (Excel, PDFs, etc) to add to one's ideas. The author of the idea below attached a phenomenal Excel file to the write-up which goes through each point / comment in crucial detail. If you would like to see that Excel, well you are just going to have to apply as current members have access to it.

Tronox

Situation Type: Distressed/Bankruptcy

Investment Idea Synopsis

• Recommend purchase of 9.5% Senior Unsecured Notes (Ticker: TRX) at 75 and subscribing to rights offering at $10.40 per share a 40% discount to implied market value.
• Recommend purchase of L+700 bp (2% LIBOR Floor) DIP/Exit Facility at approximately 96(W/OID) at syndication.

With a strong management team, reduced debt burden and settlement of legacy liabilties Tronox represents an attractive investment opportunity. Tronox's projections are conservative and they should be able to achieve $145mm of EBITDAR in 2010. They have expsoure to fast growing markets in Asia through Australian JV and 40% of their volume is on long-term multi-year contracts with blue chip customers. At current trading levels you are creating the post-reorg equity at 6.5x 2010 projected EBITDAR of $130mm. Plan EV will likely be struck around this valuation as well, approximately $850mm. At exit the company will have $450mm of secured debt and net debt of $390mm and have 3x net leverage. In estimating potential returns, Tronox is best looked at as a distressed LBO, with the equity being created through the bond. No multiple expansion is need to generate a 30% IRR under relatively conservative assumptions for free cash flow with every dollar of debt paydown increasing equity value. The following analysis is base on the bonds having 80% pro forma ownership post-reorg. It would not be unlikely to see a sale to Huntsman in the future, albeit at a much higher valuation.

Investment Idea Write-Up

Tronox was spun off from Kerr-McGee Corporation in 2006. At the time of the spin-off, the Company was burdened with substantial legacy liabilities that are not related to its operating TiO2 or Electrolytic businesses. Legacy liability costs have consumed substantial cash flow, resulting in an inability to continue to service Tronox’s debt. Due to the continued impact from legacy liabilities, exacerbated by credit market conditions and the resulting tight liquidity situation, certain of Tronox’s U.S. businesses and foreign affiliates filed for protection under Chapter 11 of the United States Code on January 12, 2009

The Chapter 11 filing does not include any of Tronox’s foreign operating subsidiaries. Tronox was set to sell the majority of its assets in a 363 sale to Huntsman for $415mm. An ad hoc bondholder group of the 9.5% Senior Unsecured Noteholders has proposed a plan of reorganization in conjunction with Goldman Sachs as replacement DIP and exit lender and the support of the Debtor. In, addition the EPA, a major other unsecured creditor, has reached an agreement to take $115mm cash and 88% of litigation proceeds against Anadarko Petroleum (purchased Kerr-McGee). The $115mm will be funded by a $105mm rights offering backstopped by the bondholder group and open to unsecured creditors who are accredited investors. On December 22, Huntsman dropped its motion to enforce the 363 Sale Bid Procedures and the debtor is committed to moving towards confirmation of the ad hoc bondholder plan. The timeline assumes approval of a replacement DIP facility(converts to exit facility) by 12/31/2009; 4/30/2010 approval of the Disclosure statement; 6/30/2010 plan cofirmation.

Company Brief Overview

Tronox Incorporated (TRXAQ or the Company) is the fourth largest producer of titanium dioxide (TiO2) pigments (93% of sales) in the world. Titanium dioxide is used in a range of products for its ability to impart whiteness, brightness and opacity. The pigment product is used in coatings for residential and commercial paint, industrial, automotive, specialty market, plastics such as polyolefins, PVC, engineered plastics, and paper and specialty products such as inks, food, cosmetics. The Company also produces electrolytic and other chemicals (7% of sales) used in batteries, pulp and paper, and pharmaceuticals, semiconductors, high-performance fibers, specialty ceramics, and epoxies.

− Sales by Geography: United States 53%, Australia 18%, Germany 18%, and the Netherlands 12%.

− Sales by Segment: Pigments 93% and Electrolytic/Other Chemicals 7%.

− Sales by End-markets: Coatings 70%, Plastics 21% and Paper and Specialty 9%.

− TiO2 Market Share: DuPont 22%, Cristal (owned by Saudi National Industrialization Company), 14%, Tronox 12%, Kronos 10%, Huntsman 10% Other 32%

With a strong management team, reduced debt burden and settlement of legacy liabilties Tronox representsan attractive investment opportunity. Tronox's projections are conservative and they should be able to achieve $145mm of EBITDAR in 2010. They have expsoure to fast growing markets in Asia through Australian JV and 40% of their volume is on long-term multi-year contracts with blue chip customers. At current trading levels you are creating the post-reorg equity at 6.5x 2010 projected EBITDAR of $130mm. Plan EV will likely be struck around this valuation as well, approximately $850mm. At exit the company will have $450mm of secured debt and net debt of $390mm and have 3x net leverage. In estimating potential returns Tronox is best looked at as a distressed LBO, with the equity being created through the bond. Nomultiple expansion is need to generate a 30% IRR under relatively conservative assumptions for free cash flow and every dollar of debt paydown increasing equity value. The following analysis is base on the bonds having 80% pro forma ownership post-reorg. It would not be unlikely to see a sale to Huntsman in the future, albeit at a much higher valuation.

Recovery

Adjusted for particpation in the rights-offering you are fully covered if you purchase the bonds at 75 with 2009P EBITDAR of $126mm at a 6.5x multiple and maintain significant upside.

Comps

Huntsman, which was bidding for Tronox has 6.5x leverage and trades at 8.2x 2010E EBITDA and Kronos trades at 50x LTM EBITDA and 12.2x 2008 (Sr Sec Notes due 2013 yields 15%). Dupont (albeit far more diversified), the largest TiO2 producer with 20% of the market trades at 8.1x. Solutia, a post-reorg chemical name with 50% of its revenues tied to automotive and 3.5x levered trades at 7x 2009 and 6.3x 2010. Tronox should trade at a premium to Solutia.

Plan Summary

− Reorganized Business: Reorganized Tronox will emerge from chapter 11 as the owner and operator of the headquarters facility at Oklahoma City, Oklahoma and the titanium dioxide facilities at Hamilton, Mississippi and Botlek, Netherlands. Reorganized Tronox also will own and operate the electrolytic chemical facility at Henderson, Nevada (but Reorganized Tronox will not be responsible for environmental remediation at that site related to legacy contamination) and will hold Tronox’s interests in BMI, Landwell and the Tiwest Joint Venture in Australia. Reorganized Tronox will be funded by the Replacement DIP Facility, which will convert to exit financing on the Effective Date.

− Recoveries for the Government/Environmental Settlement: In full satisfaction of all claims filed by the United States and its instrumentalities, and state, local or municipal governmental entities and in settlement of all civil obligations arising under environmental laws related to Tronox’s legacy environmental liabilities, these governmental entities will receive, collectively, $115 million in cash, 88% of Tronox’s interest in the Anadarko Litigation and certain other consideration. These amounts will be used to fund custodial trusts that will conduct remediation at sites presently owned by Tronox and satisfy remediation obligations at sites that are not owned by Tronox but at which Tronox may be liable for certain remediation costs. Under the Plan, reorganized Tronox will emerge from chapter 11 free and clear of such liabilities to the maximum extent provided under the law and all such claims shall be discharged.

− Recoveries for Tort Claimants: Tort Claimants, who include, among others, holders of claims for personal injury and property damages arising from or related to environmental contamination, chemical, asbestos, benzene, creosote and other exposure, collectively will receive $7 million in cash, 12% of Tronox’s interest in the Anadarko Litigation and proceeds of applicable insurance policies.

− Rights Offering: Holders of allowed general unsecured claims that are “accredited investors”, as that term is defined in Rule 501 of Regulation D of the rules and regulations promulgated under the Securities Act of 1933, will have the opportunity to participate in a $105 million rights offering that will be backstopped by the Bondholders. Participants in the rights offering will receive 70% of the equity in Reorganized Tronox.

− Recoveries for Holders of General Unsecured Claims: Holders of allowed general unsecured claims will receive their pro rata share of the GUC Pool, which will be funded with 30% of the equity in Reorganized Tronox.

− Recoveries for Holders of Private Party CERCLA Claims: Recoveries for claims of private parties under CERCLA and similar state statutes will be divided equally between participation in the GUC Pool and the Tort Claims Pool.

− Anadarko Litigation: Interests in the Anadarko Litigation will be transferred to a litigation trust for the benefit of the government entities and those claimants sharing in the Tort Claims Pool. This trust will be administered by a trustee to be appointed by Tronox and the United States, in consultation with the representatives for the Tort Claimants and other governmental entities.

- Recovery for Existing DIP and Prepetition Lenders/Lender Litigation: The Existing DIP Facility and Prepetition Facilities will be paid in full in cash with the proceeds of the Replacement DIP Facility. While the Term Sheet preserves the suit of the Creditors’ Committee currently pending against the Prepetition Lenders (Adv. Proc. No. 09-01388), Tronox, the Creditors’ Committee and the Prepetition Lenders have reached an agreement to resolve that suit. Such resolution will include a release of the Prepetition Lenders from the claims underlying that suit. The parties intend to seek the Court’s approval of that settlement once it is documented

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