Distressed Debt Investing

4.12.2010

Distressed Debt Concessions and Settlements

A pivotal aspect of distressed debt investing is the negotiations among opposing (read: warring) creditor factions. Senior creditors may want one thing, but subordinated bond holders want another. Sometimes people throw the "cram down" rule as a gauntlet in negotiations when in fact they may not even have the necessary stipulations as required by 1129 of the bankruptcy code to cram down a dissenting creditor class. Many of these negotiations are worked out behind the scenes - when evaluating an investment in a bankrupt creditor, it is prudent to play out all likely scenarios to see where ultimate recovery will come out.

Some of the more interesting cases are when a single creditor class has differing views about how a settlement or concession may play out. This is important, because under the code, from the US Courts website:

Under section 1126(c) of the Bankruptcy Code, an entire class of claims is deemed to accept a plan if the plan is accepted by creditors that hold at least two-thirds in amount and more than one-half in number of the allowed claims in the class.

This exact situation is playing out in Tribune's bankruptcy proceedings. Some background: Last week, Tribune announced it had come to an agreement between Centerbridge, J.P. Morgan and certain other senior secured lenders that would enable the company to file a plan and possibly emerge from bankruptcy. Under the settlement, Centerbridge and other pre-LBO senior debt holders would receive 7.4% of the cash, debt, and equity of the reorganized debtor's distributable enterprise value. The catalyst for this settlement was Centerbridge and other creditor's assertion that the LBO was effectively a fraudulent conveyance. On the news, the bank debt traded up a couple of points. To note, in the marketplace, a settlement was widely expected and in my opinion the bank debt traded up due to the 7.4% distribution being slightly lower than the 10% thrown in the market running up to the announcement.

This is where things get interesting. I have embedded the full response below.

Tribune AdHoc Lender Response

The ad-hoc lenders, which I listed in a previous post, and include some pretty big names in distressed debt are saying: "Nope. This won't do." And because they represent 42% of the bank debt, people should listen. From reading the document, it is readily apparent their main issue is that there are far too many releases being granted in exchange for nothing. Further, the bank group, via their post-re org equity interests, would fully indemnify Sam Zell, Tribune's directors and officers, the bank debt arrangers, etc. Everyone wins except the bank debt holders.

The ad-hoc lenders are asking the court to end exclusivity so that they themselves may file their own plan of reorganization (this will be their third attempt). Their plan looks to either shut down Centerbridge's claims of fraudulent conveyance by filing a "subsidiary only plan" (see above document for explanation). They also consider setting up a litigation trust among other actions which may allow the company to exit bankruptcy quicker as the company could emerge from bankruptcy and the litigation trust could deal with causes of action relating to the LBO.

After the close today, Tribune filed its own plan. We will find out soon enough where the direction of the case is headed because also filed tonight on the docket is the Amended Agenda of Matters Scheduled for Hearing on April 13th, 2010 at 10:00AM (tomorrow). Item 14: Debtors' Motion for an Order Pursuant to 11 U.S.C. 1121 (d) Further Extending Debtors' Exclusivity Period ... Responses Received: The above docket I have embedded.

We do not know which way the judge will rule in this one. If the ad-hoc group holds itself together (I am sure J.P. Morgan will be working the lines to work people over to their side), I do not see how the current plan gets confirmed. I have to think either settlement gets renegotiated. We will see though. Will be an interesting day in court.

4.11.2010

Distressed Debt Fund Commentary

A few months ago, we took some time out to profile Third Avenue's Focused Credit Fund. We were particularly impressed with some of the commentary coming out of the manager's letter.

As a side note, if you work at Third Avenue, can you please shoot me an email (hunter [at] distressed-debt-investing [dot] com). Have a question.

We thought we would check in and see if Third Avenue's managers had released more commentary, and we were please what we found their 2010 First Quarter Report (yes - I know this came out at the end of January...don't shoot the messenger).

What I found interesting reading through the various manager's commentaries were the fact that the value funds had invested in a few of the distressed situations which they worked with the credit team to identify. For example, Curtis Jensen in the small cap value fund notes:

Energy XXI Senior Notes represent the Fund’s second debt investment in a U.S. Gulf of Mexico-focused oil and gas producer. Securities valuations of Gulf of Mexico (“GOM”) energy companies like Energy XXI had been decimated in late 2008 following the disruption brought on by Hurricanes Ike and Gustav. The dramatic collapse in commodity prices during that period further pressured the industry’s operating results and, in many cases, led to dramatic accounting-based asset impairments. Energy XXI’s production levels, for example, fell more than 26% in the first quarter following the hurricanes and GAAP accounting resulted in a $580 million impairment of the company’s oil and gas reserves. The opportunity in Energy XXI Notes surfaced at the end of last year while the company was in the midst of a debt exchange offer designed to address a capital structure ill prepared for these sorts of adverse developments. We believed that the company’s “troubles” – both financial and operational – were temporary and fixable, that our capital, as creditors, was well protected and the investment had a number of ways to win:

• the proposed exchange offer and a coincident private financing included a credit-enhancing common stock offer that also extended the company’s debt maturities;

• production that had been interrupted because of the hurricanes would return, in time, along with additional production pending completion on more recent projects, bolstering both cash flow and reserves; the company was due to collect the proceeds of a substantial insurance settlement, further enhancing corporate liquidity;

• our multi-pronged valuation work, which relied on asset-based production and cash flow metrics, suggested our downside was well protected (i.e., the probability of a loss of capital seemed remote) while the Notes, trading at a price of around 81% of face value at the time of acquisition, provided an equitylike return of more than 17% and a current yield of approximately 12%;

• creditors like the Fund could get further comfort from the relatively strong covenants within the terms of the Notes and those in the company’s bank credit facility;

• While unnecessary for a successful investment, the company’s exposure to a potentially large exploratory success would further enhance overall corporate value;

• finally, other facts, taken together, strongly suggested to us that management was intent on improving the balance sheet. These clues included i) the company’s most recent proxy statement that requested a sizable expansion of the company’s authorized share capital, signaling a potential future equity raise; ii) new “change of control” language within the new notes indenture that seemed to contemplate the impact of an expanded equity base; iii) the fact that the company itself had repurchased $126 million face amount of Notes at a cost of $94 million1, suggesting a proactive approach toward enhancing the corporation’s financial flexibility; and iv) comments on the company’s recent conference calls and presentations committing to “debt reduction” and “further strengthening of the balance sheet.”

While subsequent events at the company largely support our thesis (a thesis developed with our colleagues on the Third Avenue credit team), the investment continues to face a number of hard-to-handicap risks, chief among them: i) operational risk (hurricane season starts in June!); ii) political risk (uncertainty related to how the Obama administration might change the industry tax regime or rules on access to reserves); and iii) deal risk (the possibility that significant new leverage is introduced as the result of either a debt-financed acquisition or a takeover of the company by a highly leveraged acquirer).

Readers active in the distressed debt market will know Energy XII was a hot topic. And given where those notes are trading right now, the investment looked like it paid off.

Let's move on to the credit team's commentary. And as discussed in previous posts here: Lots of capital is flowing to the distressed space: The Credit Fund's assets grew from $280M to $545M at the end the quarter. Their performance slightly lagged the Barclays HY Index and CSFB Leveraged Loan Index due to a position in Blockbuster's Senior Secured Notes (a hotly discussed topic on the Distressed Debt Investors Club site) and high cash balances.

On the market's returns in the quarter:

Market returns were led by CCC-rated issues which returned nearly two times the index return in the most recent quarter. This included a number of higher-risk Finance company bonds. The Finance sector had the highest return in the high-yield index for the quarter, with a return of 9.25%. For many of the Finance sector bonds that performed well, Fund Management determined there was not adequate information or transparency available on specific companies to be able to obtain a high enough conviction level that there would be minimal downside risk. These bonds included AIG, ILFC, Rescap, Aiful, Takefuji, as well as several hybrid/perpetual preferre stocks of U.S. and European banks.

On the market pullback we discussed in February:

We view this market pullback, which has continued into February, as constructive and a good opportunity for us as investors. As we have said in the past, “Trees don’t grow to the sky” and this is especially true in the credit markets. It seems that investors are finally paying attention to thefundamentals and capital structure of specific companies since the rally in the credit markets began in March 2009. In general, during this rally, the riskiest securities benefitted the most. Returns on CCC-rated high-yield bonds exceeded 100% in 2009, despite the fact that many of these companies have over-leveraged balance sheets and their cash flows from operations have declined meaningfully.

Risk appetites for these types of companies appear to be diminishing. Companies that report disappointing earnings or have uncertain outlooks have seen their security prices decline recently. This is the type of market we favor and believe we can excel in – it is what we call a “Credit Picker’s” market. We believe that investors should be invested with a manager that focuses on credit selection and carefully measures the upside potential versus downside risk of each security, as opposed to investing with a manager that just buys the riskiest securities in hopes that they will increase.

Apparently they were also caught off guard on how fast the market snapped back in March. I tend to agree - that this is the kind of market where the wheat is separated from the chaff. Especially given how volatile the market feels when you are trading it (i.e. in the morning you will not be able to buy a bond, bad news comes out, and then you would not be able to sell the bond in the afternoon). Credit selection is so important in a market like this.

From reading their commentary, they believe that returns for the next few years should be moderately positive but investors should not look to 2009 as a barometer for returns going forward. And as noted in previous posts on this blog, the refinancing wall of 2012-2014, despite being worked down in past months, still is a monstrous number to the tune of $600-$700B.

The manager, Jeff Gary, then goes on to talk about some individual investments. This is a very good read and I suggest you go read it. The one I will post here is again on Energy XXI to give the reader more perspective on the investment:

Energy XXI (“EXXI”) is an independent oil and natural gas exploration and production company with operations focused in the U.S. Gulf Coast and the Gulf of Mexico. (This credit is also discussed in the Third Avenue Small-Cap Value Fund shareholders’ letter, which you can refer to for additional information.)

Due to hurricanes which disrupted production in the Gulf of Mexico and the collapse in commodity prices, EXXI ran into liquidity issues. During the fourth quarter, EXXI attempted to do a debt exchange whereby it would exchange approximately 50% of its $625 million 10% Senior Notes for new 16% second lien secured notes at a price of 80% of par. Additionally, EXXI planned to retire the $125 million in 10% bonds the company had purchased to reduce its overall debt load.

Based on our proprietary research, we determined that EXXI’s oil reserves more than covered the value of its debt at par and the 10% notes were trading in the low 80 dollar price range. When we discussed the rationale for the debt exchange with management, they said there were two key reasons. First, it would reduce slightly its overall debt. Second, they wanted to modify the “Change of Control” provision in the new 16% second lien notes so it would be different than the 10% Notes. A “Change of Control” provision is standard in high-yield bonds and provides that if a company is bought out by another company, then the bondholders can force the company to repurchase their bonds at a price of 101% of par.

EXXI wanted the flexibility to be able to issue more than 50% of their outstanding common stock in a new acquisition deal. This would have triggered a “Change of Control” in the 10% notes. This led us to conclude that management wanted to do an acquisition funded with almost all equity, in order to substantially reduce its ratio of debt to equity. If this happened it would positively impact the bonds. We purchased the 10% senior notes and agreed to the debt exchange. Following the debt exchange, the combination of the new notes traded at a higher price than our cost basis.

In November 2009, EXXI announced that it was purchasing interests in oil properties from Mitsui & Co. for $283 million. These are interests in oil fields that EXXI already owns and operates. They were able to negotiate a favorable purchase price and will incur almost no additional operating costs. EXXI then completed an equity and convertible bond offering to fund the entire transaction.

EXXI owns interests in two deepwater exploration fields being drilled and operated by McMoran. Our analysis attributed no value to these fields, since there was no discovery yet but they were drilling the wells and had incurred costs. In January, EXXI and McMoran announced favorable findings for one of these wells. The stock now has a market capitalization of $1 billion and the 10% and 16% notes we own now trade at par and 115% of par, respectively.

Spectacular analysis.

And finally, in a footnote, there is commentary on the fund's top 10 largest issuers as of January 31st:

The following is a list of Third Avenue Focused Credit Fund’s 10 largest issuers and the percentage of the total net assets each represented, as of January 31, 2010: Swift Transportation, 4.2%; Energy XXI Gulf Coast, Inc., 3.8%; CIT Group, Inc., 3.0%; TXU Corp., 2.9%; Lyondell Chemical Co., 2.9%; Pinnacle Foods Finance LLC, 2.8%; First Data Corp., 2.7%; FMG Finance Ltd., 2.7%; Georgia Gulf Corp., 2.5%; and Culligan International Co., 2.3%.

I know most of these names well and will try to write up a snippet about each in the coming weeks. I will note, that a lot of these names have run substantially since Jan 31st.

Overall, very strong distressed debt commentary out of the Third Avenue's Credit Team.

Falling Levels of Distressed Debt

As I have noted in previous posts, the opportunity set for distressed debt has fallen immaculately over the past 12 months. Two charts from Bloomberg confirm this.

The first, is the number of distressed bonds traded. From Bloomberg: "This represents the number of distressed bonds traded during the previous day's market. Distressed is defined as any bond that trades at greater than 1000 basis points over the benchmark Treasury."

Here is the 1-year chart:

And the same chart since the index begins (1/17/2008):

The other index we can look at on Bloomberg is a similar chart, but instead this one tracks issuers, not issues. So for example, if one credit had 30 issues (read: Lehman Brother Holdings), the above charts would count each of those issues. From Bloomberg again: "This represents the number of issuers whose distressed bonds traded during the previous day's market. Distressed is defined as any bond that trades at greater than 1000 basis points over the benchmark treasury."

Here is the 1 year chart:

And the chart since the index began (same date as above):

Both these charts tell the same story: The opportunity set has gotten a lot weaker.

None of the four charts above pull in distressed bank debt. Empirically, from my seat on the desk, it is not as bad as the charts above indicate, but it is still horrible compared to late 2008, early 2009. What has contributed to this: Lots of capital chasing returns in the space combined with an improving economy. In bank debt land, you also have an issue of CLO's not wanting to sell any sub par exposure to realize overcollaterization hits and hence you have something I like to call: "An irrational holder."

All is not lost though, in the past week there has been some pretty major decisions in distressed debt land (one of the reasons for the lack of posts), which has provided some interesting opportunities for investors. We are going to explore these over the coming week and hopefully learn something from each of the decisions.

4.07.2010

Who is playing what Distressed Debt Deal?

In the distressed debt world, it is helpful to know who you are up against and who's side you are playing for in a particular deal. But how do you find this information out? Let's use Tribune as an example.

For reference, here is a link to Tribune's Claim Agent site: Tribune's Claims Agent

Tribune has been a favorite of the event driven / distressed hedge fund space for over 2 years now. Let's say you are interested in investing in the bank debt but want to get up to speed by talking to other investors you may know that already hold the position.

I goto the docket, and start poking through filings that could shed some light. You are looking for things like "Statement of Representation" which is just a fancy way to say XYZ legal firm is representing ABC Creditor. In Tribune, the first thing that pops up when searching starting with the most recent documents is Docket #3927.

It reads:

...3. HBD and YCST represent a number of individual creditors in connection with holdings of indebtedness governed by the Credit Agreement, dated as of May 17, 2007 (as amended, the “Credit Agreement”), by and among Tribune, each lender from time to time party thereto, and certain financial institutions as administrative agent, syndication agent, codocumentation agents, and joint lead arrangers and joint bookrunners.

4. The names and addresses of the creditors currently represented by HBD and YCST (collectively, the “Lenders”) are identified on Exhibit A, attached hereto. The aggregate principal amount of claims held by the Lenders against the Debtors currently totals approximately $3.8 billion.

In the above text, HBD and YCST stand for two legal firms: James O. Johnston, on behalf of Hennigan Bennett & Dorman LLP (“HBD”), and M. Blake Cleary, on behalf of Young, Conaway, Stargatt & Taylor, LLP (“YCST”).

And read that again - The creditors listed hold $3.8B of the claims. That is a big number. The file continues by listing the lender (with addresses). Here are some the names on the list.

Anchorage Advisors, L.L.C.

Avenue Investments, LP

Avenue Special Situations Fund IV, L.P.

Avenue - CDP Global Opportunities Fund, L.P. (US)

Avenue International Master, LP (Master)

Avenue Special Situations Fund V, L.P.

Canyon Capital Advisors, LLC

CFIP Master Fund, Ltd. c/o Chicago Fundamental Investment Partners, LLC

Contrarian Funds LLC

A Number of Franklin Templeton affiliated funds

GoldenTree Asset Management, LP

Goldman Sachs Loan Partners

Greywolf Capital Partners II LP

KKR Financial CLO 2005-1, Ltd.

KKR Financial CLO 2006-1, Ltd.

KKR Financial CLO 2007-1, Ltd.

Oregon Public Employees Retirement Fund

KKR Financial Holdings III, LLC

KKR Strategic Capital Holdings I, L.P.

Knighthead Master Fund, L.P.

Latigo Master Fund Ltd.

LP MA1, Ltd.

SEG LP MA2, L.P.

SEG Latigo Master Fund Ltd.

Luxor Capital Group, LP

Marathon Asset Management, LP

Newstart Factors, Inc.

Oaktree Capital Management, L.P.

Onex Credit Partners

Scoggin Capital Management LP II

Scoggin International Fund LTD.

Scoggin Worldwide Distressed Fund, LTD

Taconic Market Dislocation Fund II LP

Taconic Market Dislocation Master Fund II LP

Taconic Capital Partners 1.5 LP

Taconic Opportunity Fund LP

Värde Investment Partners, L.P.

Viking Global Equities LP

Viking Global Equities II LP

VGE III Portfolio Ltd.

Waterstone Market Neutral Master Fund, Ltd

Waterstone Market Neutral Mac51 Fund, Ltd

York Capital Management, L.P.

So just eyeballing it: Avenue, Canyon, Contrarian, Franklin Templeton, Goldentree, Knighthead, Luxor, Oaktree, Onex, Scoggin, Taconic, Viking, and York are in the mix. That is a strong list of solid hedge fund names.

Unfortunately, these filings don't tell you where these assets were being bought. But if you know someone at one of these places, you could make a call, get a summary of the situation, and you are off to races.