Distressed Debt Research: Nebraska Book Bankruptcy

This morning Nebraska Book filed for bankruptcy in Delaware and announced an agreement with a number of creditors in a negotiated restructuring. For those that are interested, you can view the docket here:

Nebraska Book Bankruptcy Docket

In his affidavit to the bankruptcy court, Alan Siemek, CFO of Nebraska Book described the reasons for the bankruptcy filing, as well as the negotiated restructuring the company hopes to move forward with. For those that have not followed Nebraska Book ("NBC" or "the Company"), the company operates two divisions: 1) Its Bookstore division operates nearly 300 managed, leased or owned college bookstore selling new and used textbooks and 2) Its Textbook division which distributes textbooks nationwide. The company was purchased by its current equity sponsor, Weston Presidio in early 2004 with a small equity check and a substantial amount of debt.

Why did the company file? Their trade creditors tightened up on them in the face of a large, unanswered 2011 debt maturity coming due. According to the affidavit:

"Further compounding the Debtors’ refinancing efforts, the Debtors’ business model typically calls for publishers and other merchandise vendors to provide approximately $200 million of new books and other merchandise on normal credit terms in July and August in advance of the back to school" rush. These normal credit terms, which may not be available to the Debtors during the 2011 "back to school" rush because of the uncertainty regarding the refinancing of their debt structure, usually allow the Debtors the opportunity to sell the textbooks (or return them) and sell other merchandise priorto having to pay for the items. This trade credit has been less available to the Debtors in the last several months as publishers and vendors became increasingly concerned about the Debtors’ refinancing process. Absent some action by the Debtors to de-lever their capital structure, the Debtors believe that it is highly unlikely that the publishers and vendors will extend the normal credit terms during the upcoming "back to school" rush. In fact, in the weeks leading up to the Petition Date, all five of the Debtors’ largest suppliers of new textbooks requested that the Debtors pay cash in advance for new textbook orders."

When trade starts asking for cash up front, most debtors fates are sealed.

With the writing on the wall, NBC and its advisors approached interested parties and stakeholders to explore debt restructuring options. It seems the debtor has reached an agreement with 95% of its senior sub note holders and over 75% of their 11% senior discount notes. For reference, here is the corporate and capital structure before the filing (taken from the prospectus of the 2nd lien notes):

As of the filing date, $26M was outstanding under the $75M ABL credit facility (including LOCs).

Under the plan:

• The company has secured a DIP facility comprised of $75M revolving DIP facility and a $125M Term Loan (DIP Term Loan: L+700, 1.25% Floor - take that Dodgers!)
• Trade creditors will be paid in full
• 1st Lien ABL credit facility will be paid in full
• 10% Senior Secured Notes due 2011 paid in cash with adequate protection (more on this later)
• 8.625% Notes will receive a combination of $30.6M in cash, $120M new unsecured note, and 78% of the new company's equity (the cash coming from a new second lien note the company plans to issue)
• Holdco notes will receive 22% of the new company's equity
• Westin Presidio (the sponsor) will receive warrants to buy 5% of the company at a $550M enterprise value (if they agree to support the contemplated restructuring)

In addition, NBC announced that its FY 2011 results (ended March, 31st) with revenues of $598M and EBITDA of more than $60M. For reference, the company generated $75M in EBITDA in FY2010 and $72M the year before.

Near the end of the day, JPM put out markets for the bonds

• 10% Senior Secured Notes: 98.75-99.75
• 8.625% Senior Subs: 70.5-72.5
• 11% Holdco Notes: 5-10

While it hasn't been detailed yet, let's try to figure out the capital structure of the company post the restructuring:

Uses of Cash

1. ~$26M cash to ABL
2. ~$200M cash to Senior Secured Noteholders
3. ~$30.6M cash to Senior Sub Noteholders
4. Administrative fees

Sources of Cash:

1. New contemplated Second Lien Note offering
2. $125 Exit Facility (let's assumed rolled from DIP Term Loan)
3. Current Cash Balance ($20M) + free cash flow generated throughout the bankruptcy

You will note I did not add the new unsecured note as a source of cash as it looks like they will be receiving that without putting up new capital. If we assume free cash flow generated through the bankruptcy will pay down the DIP revolver usage and pay admin fees, the post restructuring balance sheet will look something like this:

• $125M rolled senior secured exit facility
• ~$100M second lien note
• $120M unsecured note

Or total debt of $345M. This seems high relative to $60M of EBITDA or 5.75x. The $345M is approximately equal to the prepetition debt less $150M (from the petition: "The RSA contemplates a pre-arranged restructuring in chapter 11 through which the Debtor will remove approximately $150 million in debt from their prepetition balance sheet while paying general unsecured creditors in full")

There are $175M of subs outstanding as of the petition date. At a current market price of 72 cents on the dollar, the market value is approximately $125M dollars. Remember the subs are getting $30.6M of cash and a $120M unsecured note and 78% of the company's equity. In essence, the market is saying that the unsecured note will trade well below par and the equity is near worthless.

Admittedly it is hard for me to say the company's equity is worthless: Assuming an onerous rate of 7% on the exit, 12% on the second lien and 18% on the unsecured notes, total interest expense will, at worst case, be around $40M. And with $5M of maintenance capex and negligible taxes, EBITDA would have to decline to $45M from $60M (higher if you adjust for PF cost saves), before the company burned cash.

With all that said, I prefer the margin of safety in the pre-petition Senior Secured (second lien to ABL) Notes as well as the DIP Term Loan (and possibly Exit Facility depending on the covenants). The Senior Secured Notes will be taken out at par with cash on the effective date of the restructuring. In addition, according to this filing, an Ad Hoc group of Senior Secured note holders will be receiving MONTHLY interest payments (at the non-default rate) as adequate protection as well as payment of ordinary fees / expenses.

The Senior Secured note holders were not even entitled to this under the pre-petition intercreditor agreement (section 5.4 of the intercreditor provides the only form of adequate protection Second Lien Note holders may seek are replacement liens and superpriority claims that are junior to the superpriority claims of the First Lien lenders). The filing states that the reason for the adequate protection payments in the form of cash money is to avoid litigation.

Please note: The document above only references the Ad Hoc group of Senior Secured note holders. I have yet to find something that supports retail or non Ad Hoc members receiving the same kind of treatment in terms of cash payment.

There is upside here as well if the plan falls through and second lien note holders somehow become the fulcrum, creating the company at a very low valuation. The downside is the plan completely blows up, the company liquidates, etc, something I view as unlikely. At a ~9-10% yield that seems very safe, it definitely looks compelling. The sub notes to me are a more speculative investment but still have an interesting situation with the package being granted. If I had to choose, I'd definitely play higher up in the capital structure in either the DIP Term Loan or Second Lien Notes of Nebraska Book.

Read more...

Distressed Debt: Weekly Links of Interest

What we're reading this weekend at Distressed Debt Investing:

Commentary on the Supreme Court's blockbuster decision in the Stern v Marshall case; Marshall for those not aware was better known as Anna Nicole Smith. More commentary here as well. [Weil Bankruptcy Blog & The Bankruptcy Litigation Blog]

Someone sees some potential value in Seahawk Drilling's equity [Oddball Stocks]

Note from Leaders in Investing Summit featuring Leon Cooperman, Larry Robbins, Bill Ackman, Howard Marks and more [Market Folly]

More red flags from Sino Forest [Bronte Capital]

The New Yorker looks at insider trading [New Yorker]

Greenbackd returns (!) with a look at "Profit and Value" strategies [Greenbackd]

Smaller is better, when it comes to hedge funds [Financial Analyst Journal]

A very detailed look at earnings multiples and their flaws [Value Restoration Project]

Incredible graph of the long term performance of treasuries vs. stocks. vs the Barcap Agg [Research Puzzle]

Read more...

Largest Weekly High Yield Outflow on Record

This afternoon, Lipper reported that high yield saw its largest weekly outflow EVER, with $3.4 billion leaving high yield funds on the week. To put it in context, here is the updated Top 5 weeks of all times in terms of outflows:

1. 6/22/2011: $3.4 billion of outflows
2. 8/6/2003: $2.6 billion of outflows
3. 5/12/2004: $2.2 billion of outflows
4. 5/12/2010: $1.7 billion of outflows
5. 6/15/2011: $1.6 billion of outflows

Apparently in high yield, you should only invest from January until April, go to the Hamptons early, and come back late August (unless of course this is 2008, and then you should come back in October/November).

Most market participants knew the number was going to be big. Rumors swirled on the desk of $2.5B+ so a large number was not a surprise. But I do think THIS large of a number was a surprise. With that said, while it has felt "squishy" throughout the week, it's been quite orderly. The curve has definitely helped, but according to the CS High Yield Index, there hasn't been that much pain:

Of course, I, more so than most, hate when people only show me one year of data. Let's put this chart in perspective a little bit shall we:

This is the same index (CS HY Index II Average Price) over the past 5 years. Our little draw-down looks quite small when you compare it to the carnage of late 2008. And if you look at the underlying statistics, of the most liquid bonds out there, you saw bonds retrace 1-2 points (more spread widening associated though with the move in rates). The cuspier names were definitely hit hardest; names that had the weakest performance over the past five days include names like Verso Paper, MBIA, Realogy, Rite Aid, and Hawker Beechcraft whose bonds dropped 3.5-5.5 points over the past five days.

One of the largest caveats market participants have with analyzing the AMG data is that it is backyards looking. This is true, but I must add that, in my experience, fund flows are a factor in determining how aggressive syndicate desks can be in terms of pricing new issues and covenant negotiations. Weaker flows means wider and sometimes pulled new issues (this week a number of deals were pulled). And because the new issue market is usually used as a comp from IG all the way down to bank debt, a back up in new issue spreads will push secondary spreads wider.

One particular nuance that I have felt throughout the past few weeks is that there is just not a whole lot of sellers of high yield credit. Since mid 2009, a number of players in the primary markets ranging from insurance to pensions to mutual funds have seen very weak allocations on "on-the-run" deals. And when they get these allocations, people are putting the bonds away never to be seen on the street again unless a real panic has set in and weak hands are forced to capitulate. That is definitely NOT happening here. We are still a ways away from that.

So while the AMG number is large, the only takeaway I have is that if you are playing the new issue market, you can use it to your advantage to ask for better terms on covenants and a wider discount to secondaries (in both HY and IG we've seen primary deals come THROUGH secondaries which is a sign of a frothy market). Maybe you pick up an event driven name one to three points cheaper, but nothing out there is indicating to me that people are panicked, or buyers are fully on strike. The meme that defaults will be low in 2012 and 2013 will keep strategist recommending the asset class and certain buyers buying it.

In my office at home, I have framed the cover of the New Yorker from October 20th, 2008. I have reproduced it for you below (the title of the piece is "Red Death on Wall Street":

When you see that sort of cover on major media covers, that's when you buy bonds (and stocks). To me, there are so many other places to find value in the market other than high yield bonds (large cap tech equity for instance), especially when you consider that high yield not only has to contend with a slowing macroeconomic picture, but also the risk that rates rise (not an unfathomable possibility). If I had to bet, I bet the total return on MSFT stock, which I own, will be higher than high yield over the next 5 years. Here is a chart of HYG vs MSFT since the beginning of last year:

But for those that have to put money to work in high yield (like me for instance in certain accounts), you will not get killed, and there are a few interesting situation out there playing make wholes, asset heavy companies as well as smaller issues at the top part of the capital structure (preferably secured bonds), playing the crossover trade (still one of my favorite strategies), and a smattering distressed situations such as Nortel, Capmark, Lehman, and some exit facilities and other off-the-run bank debt names. And of course, the Russell rebalance is tomorrow and a lot of illiquid post-reorg equities will see a nice bid come in from passive players. But for the retail investor, I would not be going out and buying JNK or HYG - there are more compelling ideas out there.

Read more...

My Favorite Takeaways from the Oaktree S-1

On July 17th, Oaktree Capital Group filed its S-1 with the Securities and Exchange Commission. Many times over the past few years, we have profiled Oaktree's Chairman Howard Marks and highlighted takeaways from speeches he has given and his fantastic memos on Oaktree's homepage. In addition, I just started reading Marks' "The Most Important Thing", described by Warren Buffett: "This is that rarity, a useful book." If it's good enough for WEB, it's damn well good enough for me. When I am finished, I will put up a thorough review of the book.

With all that said, I read through Oaktree's S-1 and thought it would be a useful exercise to pull out my top 10 takeaways from the document. For those that want to follow along, you can find the S-1 here: Oaktree S-1

Enjoy.

1) Oaktree explains value investing REALLY well

In their "Business Principles", Oaktree lays out a number of fundamental tenets that guide their operation as an investment manager (commonality of interests, management fee arrangements, etc). The first business principle is "Excellence In Investing" and they go for the jugular in explaining how they do it - i.e. value investing:

"Our goal is excellence investing. To use, this means achieving attractive returns without commensurate risk, an imbalance which can only be achieved in markets that are not 'efficient'. Although we strive for superior returns, our first priority is that our actions produce consistency, protection of capital, and superior performance in bad times."

To me this speaks massively of margin of safety and the first AND second rule of investing: "Don't lose money." Further down in the document, when speaking about the investment philosophy, this quote appears:

"We believe that the best long-term records are built more through the avoidance of losses in bad times than the achievement of superior relative returns in good times. Thus, our overriding belief is that 'if we avoid the losers, the winners will take care of themselves.'"

2) Oaktree likes to play in the top part of the capital structure

Similar to commentary we've seen out of Marty Whitman and the Third Avenue Focused Credit Fund, Oaktree likes to play high up in the capital structure to minimize their downside with the possibility of equity upside in the case of the seniors being the fulcrum. That is not to say that Oaktree is going out and buying par loans, but in recent cases where they have been active (Tribune, Universal Building Products, Almatis), they are playing in the most senior part of the capital structure and buying the debt significantly less than par. From the S-1

"Most of our investment strategies focus on debt securities and many of our funds’ investments reside in the senior levels of an issuer’s capital structure, substantially reducing the downside risk of our investments and the volatility of our segment’s revenue and income. Debt securities by their nature require repayment of principal at par, typically generate current cash interest (reducing risk and augmenting investment returns) and, in cases where the issuer restructures, may provide an opportunity for conversion to equity in a company with a deleveraged balance sheet positioned for growth."

3) Oaktree Knows When to Sell It Own Equity Well

In May 2007, Oaktree sold 15% (23,000,000 shares) of its company on Goldman Sach's private exchange valuing the company at $6.3B or a price of ~$40/share Here is the trading prices for the equity on that same exchange:

They struck while the iron was still hot in 2007 and did a service for their selling investors by not waiting. Of course they could have waited until today, but that 4 years can be a long time for people with high percentages of their net worth in illiquid stock. In addition, if you consider that at the end of 2006, when they were probably marketing this equity sale, their AUM was around $35B versus $80B today. The intrinsic value of the stock is substantially higher today that it was 4 years ago and they still sold at those levels. AND they had the thesis that we were going into an economic downturn to top it off (see next bullet point). Well played.

I also did not know they had sold equity prior to the 2007 listing; From the S-1: "We first sold a piece of Oaktree to outside investors in 2004 and again in 2006, when long-time clients acquired approximately 13% of the company."

4) They grow when the going gets (or is about to get) tough

Many times when speaking with new and emerging fund managers I hear the complaint that the best time to raise capital is when we are staring over the abyss, but at that point no one wants to allocate capital. The irony in asset management really is the best returns (and hence incentive fees) arise when its hardest to raise capital. Oaktree, and a number of other prominent distressed investors (Baupost for example) have bucked this trend. Sticky capital the answer? Here is an example from the S-1

"By way of example, from January 2007 until May 2008, in anticipation of an economic downturn, we raised $14.5 billion for two distressed debt funds, including $10.9 billion for OCM Opportunities Fund VIIb, L.P., or Opps VIIb. We commenced Opps VIIb’s investment period in May 2008 and then invested over $5.3 billion of its ultimate $9.8 billion of drawn capital in the 15 weeks following the collapse of Lehman Brothers on September 15, 2008. While that investment environment presented an outstanding opportunity for us to buy bank debt and other securities at distressed prices, the steep drop in the financial markets contributed to the $10.8 billion decrease in aggregate AUM market value in the year ended December 31, 2008. Markets recovered in 2009, resulting in aggregate appreciation of $19.1 billion and $8.7 billion in the years ended December 31, 2009 and 2010, respectively. The recovery in the financial markets continued into the first quarter of 2011, driving further aggregate market appreciation in AUM of $3.2 billion."

In addition, and the other side of the coin to this, is that they shrink when markets are frothy (I've noted in the past how they return capital early when opportunities do not exist). In the S-1, Oaktree comments that "this phase in the market cycle is likely to cause our AUM to decrease in the second quarter of 2011 and to then possibly plateau or continue decreasing in coming quarters, subject to net asset flows in other funds and fluctuations in market value across all funds."

5) Oaktree and I Think Alike on Distressed Debt

A fundamental tenet of my thought process on distressed debt investing is as follows: Increased and sometimes frantic demand for high yield paper (bonds and lev loas) is met by underwriters marketing weak companies, weak collateral, and weak covenants. This in turn leads to higher default rates and lower recoveries for credit on the aggregate which leads to lower pricing of the asset class as a whole. This is when you buy credit - not when an underwriter tells you he is marketing a covenant lite retailer levered 6x on ADJUSTED EBITDA and the book is 3 times oversubscribed.

From the S-1 (long one here - I apologize, it was too good to cut out any of it)

"One important factor we consider in assessing where we are in the cycle is the amount of debt issuance, such as high yield bonds and non-investment grade leveraged loans. We believe an increased volume of debt issuance, to the extent it reflects loosened credit standards, can foretell an increase in debt default rates and the distressed securities they often create. The chart below shows this historical correlation.

We size our distressed debt funds based on the above relationship, our assessment of the economic cycle and other factors. By sizing funds in this manner, we intend to avoid both managing too much capital when bargain purchases are scarce and too little capital when they are plentiful. As a result, we have achieved positive gross and net IRRs as of March 31, 2011 for each of our 15 distressed debt funds. The chart below illustrates two benefits of our approach to sizing funds: the consistency of our positive performance and that, in each cycle, our largest funds have tended to be our best performers. Each bar represents a distressed debt closed-end fund, the height of the bar corresponds to the fund’s gross IRR as of March 31, 2011 and the dollar amount below each bar identifies the fund’s committed capital.

In 2001 and again in 2007, we anticipated the possibility of market dislocation, based in part on the considerable amount of debt issuance in the preceding years. While we did not attempt to predict the timing of the downturn, we thought the volume of lending relative to the fundamentals created a dynamic in which issuers would likely have difficulty meeting their obligations, resulting in an increased default rate or other factors that could result in expanded investment opportunities for us. Accordingly, we raised considerably more capital than we had historically so that we would be prepared if the markets experienced financial distress, creating attractive buying opportunities."

6) Their results are incredible

I had never seen the below chart, where their distressed debt returns were showing in one listing. I had heard the rumors but never the data to back it up. Needless to say, this is a glorious chart (click through if its too small). And the thing that really sticks out at me: No negative numbers here:

Read more...

Distressed Debt: Weekly Links of Interest

Over the next few months, I am going to try to posts a weekly roundup of investment related content on the web. Some will be related to distressed debt, other to value investing in general, and maybe a few things that have to do with neither. During the weekend, I try to catch up on all the data that I've missed during the week (remittance data here I come?) and read articles forwarded to me by colleagues and friends that I may not have had time to read. Here's to hoping I add a little bit to your weekend reading stack. Enjoy

Profile on Howard Marks of Oaktree Capital [Bloomberg Markets]

RSAnimate illustrates the paradox of choice [Simoleon Sense]

Interviews with a number of prominent financial bloggers [Gannon on Investing]

Subcon and Nondebtor Entities [Jones Day]

Enchantment book review by David Merkel [Aleph Blog]

Small cap high yield panel at the Milken Institute Global Conference [Milken Institute]

Discussion on the upcoming maturity wall (hill?) [Weil Bankruptcy Blog]

Incredible presentations at the LSTA's "State of the Leveraged Loan Market" conference [LSTA]

Read more...