More Chrysler Bankruptcy Information

So the docket is beginning to fill up: Chrysler Bankruptcy Information

As of 12/31/2008, the "Chrysler Companies" (as defined as debtors and non-debtors direct and indirect subsidiaries) listed $39.3B of assets and $55.2B of liabilities. Revenue in 2008 looks to be $48.4B.

From the joint administration filing: Under a liquidation "Chrysler's first lien secured creditors will receive net present value recoveries of less than 38 cents on the dollar and possibly as little as 9 cents; the U.S. government, another secured creditor, will receive less than that; and Chrysler's unsecured creditors will receive nothing."

And the real juice: Chrysler Bankruptcy Affidavit

My takeaways:

• Filed by the CFO, Ronald Kolka.
• Goes on to talk about how imperative it is to avoid a liquidation.
• Asking the Court to approve a 363 sale, financially backed by the U.S. Gov't. 
• 30% of first lien debt holders are against the sale. The affidavit goes on to say that Chrysler bank debt trades at 15 cents on the dollar. That is definitely not the market that a certain dealer that starts with Goldman and ends in Sachs is making right this very moment.
• Goes on to talk about the things I talked about in my last post: Chrysler Bankruptcy
• Upon consummation of the 363 sale, the major assets of old Chrysler would be 8 manufacturing facilities, and related machinery and equipment with a book value of $2.3B. The U.S. Gov't would provide $200M through the DIP loan to run a wind-down and sale of the estate.
• Description of Business: No need to rehash what everyone knows.
• Organizational and Capital Structure: Outstanding amount under the First Lien is $6.9B (as of petition date). Secured by first lien in all Chrysler's assets, a 65% equity pledge of foreign subs, and other guarantees. $2B second lien delayed draw term loan. $4B TARP loan, third lien to first lien's security. $5.3B of trade debt.
• Events Leading to the Petition: Again, everyone knows this. Blame Cerberus.
• More talk on the FIAT alliance
• And lots of first day motions, fairly typical in nature.

Here is Balance Sheet:

We can try to put some kind of recovery on each of these assets, and compare to the $6.9B of First Lien Bank debt (and some trade, estimated at $800M, will have critical vendor status / 20 day rule [503b9 claims], as well as bankruptcy administration fees).  

Assuming bankruptcy fees of $1B and $800M of "20-day claims" are ahead of you, at 25-30 cents on the dollar, the bank debt is implying $3.5B-$3.8B of value. Versus $39B of listed assets, with $1.9B of that cash.  Doesn't seem that too far of a stretch - unless the DIP gets super priority, and primes the shit out everyone. Maybe those crazy hedge fund pirates holdouts had the right idea. 

There are some other interesting affidavits from the head of manufacturing, head of procurement, head of dealers, etc. These are filed under Dockets Item Numbers: 48-54. They are interesting reads. Basically go on to say how imperative this Fiat deal is to everyone in the world. 

More tomorrow on the Chrysler bankruptcy.

Chrysler Bankruptcy

Chrysler filed for bankruptcy today. For reference, as of now, this is the only docket information I can find (outside of Pacer logins)

Petitions can be found here: Southern District of New York Bankruptcy Court. Here is more information I just found: Chrysler Restructuring Website

As of right now, the Carco bank debt is trading at 25.25-27.25, with Finco (the auto financing arm) first lien trading at 77.25-79.25 and second lien trading at 52-55. Yesterday - at about this time, the Carco was trading at 23-27, with FinCo's first lien trading at 63-65 and the second lien trading at 34.5-37.5. As you can see, the FinCo lenders are loving this (up LOTS on both tranches). Maybe one of the reasons a number of funds did not play ball? Because their exposure to FinCo relative to CarCo?

And here is the White House Statement regarding Chrysler

And my takeaways (from a distressed investor:

• Chrysler will use a 363 sale for its relaunch
• Details of the Chrysler Fiat Alliance - maintain existing factor footprint, Fiat contributing technology and IP (but no capital???). And getting 20% of the stock with earn out rights of 15% more of the equity (5% tranches) for meeting performance metrics.
• UAW accepting concessions but probably won't be enough
• Lenders will receive $2B of cash on a $6.9B claim. That translates to 29 cent recovery. This will be forced on dissenting creditors (do they have the required votes?)
• Daimler waiving its $2B of second lien debt, give up its equity, and settle PBGC claims for $600M
• Cerberus waiting its $2B of second lien claim and forfeit its equity stake.
• VEBA will be established financed with a $4.6B 13 year, 9% note and will receive 55% of the new equity of Chrysler.
• U.S. Treasury receiving 8% of the new equity. Can select 4 independent directors. Canada/Ontario to receive 2% of the new equity.
• U.S will provide a $3.3B DIP as well as provide $4.7B in exit financing to New Chrysler (First Lien Term Loan with varying maturity schedules), and a $288M note which is a fee for making these loans.
• Canada/Ontario participating on a formula/basis
• Chrysler will use GMAC for financing. SO THAT IS HOW CERBERUS IS GETTING SOME LOVING IN THIS DEAL (CERBERUS OWNS ~50% of GMAC). Gmac Bond's have rallied today.
• More lambasting of smart hedge funds.
• Employees getting paid, suppliers getting paid, customer warranties getting paid. U.S. taxpayers - not getting paid.

Edit #1: This is a good read: Stubborn Lenders

Much, much more when the filings start hitting the docket. All I can say...Fiat 1 - U.S. Taxpayers 0. The Chrysler bankruptcy is going to be an interesting one.

Distressed Debt Investing Thanks You

When I started Distressed Debt Investing, I had no idea where it would go or what it would become. I knew that I wanted to enlighten experienced and inexperienced investors alike with the distressed debt investing process, what was going on in the distressed debt world, and how to profit from it. And maybe a few off topic posts where I could collect my thoughts on other value investing topics.

I am deeply humbled by all the kind words and emails that I have received over the past 4 weeks. I really am sincerely grateful. I am astounded to say that Distressed Debt Investing now has over 400 RSS Subscribers and receiving over 1000 page views a day. It is flabbergasting to say the least.

I want to thank a number of journalists and bloggers that have linked to my posts: Stephen Grocer at the WSJ, Aaron Pressman at Business Week, Gwen Robinson at the FT, George at Value Investing News, Market Folly, Abnormal Returns, Mr Markets Value, Greenbackd, Wide Moat Investing, Miguel at Nightly Investment Links, Lawrence's Blog, Barel Karsan, Noise Free Investing, The Safe and Cheap Blog, and probably a few more than I am forgetting (shoot me an email and I'll add you to this list!)

I am always here to help out our readers. If you have questions, comments, thoughts, need advice on jobs, case study questions, want to rant about GGP, or anything, you can contact me at hunter [at] distressed-debt-investing [dot] com. I will try to respond as fast as humanly possible. Also, If you want to write a guest post, please let me know - we are always looking for great content here at Distressed Debt Investing.

Once again, thank you all so much.

-Hunter

Anatomy of Common Stock Due Diligence

Generally, distressed debt hedge funds as well as event-driven hedge funds do not just go long and short distressed debt bonds. In their books (portfolios), they will also own value based equities, index hedges, private equities, cheap performing bonds, etc. One thing most of them will certainly have in their portfolios is shorts on certain equity names.

One of the best books on the subject is "The Art of Short Selling" by Kathryn Staley.

I stumbled upon this book when I found a link to a Blue Ridge Capital Reading List. For those unaware, Blue Ridge Capital was the original Tiger Cub. John Griffin, its founder, was #2 at Tiger Management working under Julian Robertson in its heyday. They are long/short value investors. Some of their biggest holdings (according to the 12/31/2008 13F) include Microsoft, Covanta, Berkshire Hathaway, National Oilwell Varco, and Mastercard (I hold two of these stocks in my personal account).

In her book, Staley goes on to list some general themes/baskets that certain shorts regularly fall. They include: "Bubble Stocks", high growth stocks with sky high multiples, stocks where the SEC filings don't quite make sense, companies that burn through lots of cash and need tons of capital, heavily indebted companies, "for sale but not sold company", companies that are hiding deteriorating earnings with one off gains, companies in secularly declining industries, or all of the above.

A problem that many short sellers find themselves is a company who's stock goes higher and higher in spite of an obviously deteriorating condition (just pick one of the above). The market is irrational at times. Many hedge fund managers covered their GGP stock in early 2008 when the stock rallied to the low 40s from the low 30s. A year and a few months later, the stock trades at 60 cents. Many funds got crushed when the government banned short selling of banks. You may be right in the long run, but when you are giving your investors month to month or quarter to quarter numbers, you need to be right in the short run. Admittedly, one of the flaws of the hedge fund model which I dutifully subscribe to as an active participant.

Now, I want to start off by saying that this post is not a recommendation one way or the other to short the stock that we are going to begin to do due diligence on. I have no economic interest one way or the other in this stock. If you do your research, figure out its a good short, then I suggest you put it on. Otherwise, look at this post as more of a way as I how I approach common stock investing (on the short side).

Just like many value investors look at the 52 week low list for long value plays, some people, including myself, look at the 52 week high list for short plays. You can access this list on Bloomberg or various other financial sites on the web (do a Google search). Earlier in the week, I saw that Darden Restaurants (DRI) had ticked off a high on April 22nd.

For those that do not know, DRI owns and operates a number of restaurant chains - very well known chains such as Red Lobster, Olive Garden, Longhorn Steakhouse, etc. I was surprised to see such a stock on the 52 week high list - why? Because in recessions, I would assume people eat out significantly less. So why not investigate and see what we can find?

The first thing that I do when researching a common stock, whether it be long or short, is read the last three annual reports. Why three? That's what my boss told me my first day on the buy-side, and I just haven't experimented enough to see if one, three, five, or ten is the right number. These can be found here: Darden Annual Reports.

One caveat. I will go back quite a few years and read the shareholder letter. I want to see if the shareholder letter actually matches up with how the company performs in future years. Also I want a realistic shareholder letter. I.E. If I read a shareholder letter from 2008 where the author is all bulled up on the economy, I generally laugh and move the idea to the short pile. And in some situations, if a business is very cyclical, I will go back to the annual reports of the last down cycle to see what was happening.

What else am I looking at when reading the Annual Reports? Not only do I want to see how the business is performing, I also want to see how management is using their capital. Were they buying back stock at the highs in 2007? Were they levering up for acquisitions in the same year? How has capex trended with sales and what is the return on that capital employed. Does CFO match trends in net income. What are the accounting assumptions?

Pension assumptions are the most overlooked information in an annual report. While DRI's pension plan is fairly small relative to the size of the enterprise, from the 2008 DRI Annual Report, DRI is assuming a 9% expected return on plan assets. Definitely aggressive in the context of real world returns.

Other things I look at: I read the notes voraciously. I want to get an insight that other people may have glossed over. Remember, investing is a zero sum game. For every winner, there is a loser. I like to win. Unfortunately, I should just do a whole post about reading an annual report, cover to cover, and I will do that in the future.

I then read the last three proxy statements. These can be found here:

Darden 2008 Proxy
Darden 2007 Proxy
Darden 2006 Proxy

Why do I read the proxy statement? Well for a few reasons. I like to see the make up of the board (and how they are paid), I want to see management holdings of stock, I like to see the proposals shareholders are voting for and how management responds, and a few others. The two most important things to look at when reading a proxy is: 1) How is management compensated and 2) What related party transactions have been taking place

In regards to #1, you want a management team that is compensated for things like return on capital, not sales. Why? Because a management team can pump up sales by spending capital on low return projects. All this will be under the report from the compensation committee. While it may be counter intuitive, I like to see management being compensated with restricted and common stock, yet I generally dislike when compensation is linked to stock performance. This just gives management an incentive to cheat and lie to boost their stock price. I want a management team to think like owners. I also want to see that compensation for a certain year was in line with what the business actually did...i.e. I do not want to see lots of bonuses paid out for a terrible year.

In regards to #2, it is fairly self explanatory. The less insider / related party transactions the better. DRI has none which is a gold star in my book.

After reading the last three annual reports and proxies, I should be fairly comfortable about what the business does, its drivers, how they make money, where the capital is being spent and at what targeted return, etc. From here I will read as many conference calls and corporate presentations I can stand. You can find the conference calls on Seeking Alpha, or if you are an institutional investor on Bloomberg or Street Events. Good investor relations departments put all their historical presentations on the website, easy to find for investors. That reminds me, I will also spend quite a bit of time reviewing the corporate website, trying to get a better understand of the business. Lots of jewels to be mined there.

Why do I read the presentations and conference calls? Well first of all, I want to figure out the shared expectations of the market and the concerns of the market. Generally, an investor relations department will tailor their presentations to analysts questions and concerns. I.E. If a company is getting a lot of questions on its liquidity in private conversations with analysts and buy side professionals, the investor relations department will stick a slide in saying how great liquidity is. Always happens. On the conference call, follow the Q/A section and see what people are asking about and concerned about. You make money in the market by having different expectations about the future than the general consensus. If you think 2010 and beyond free cash flow will be substantially higher than the analyst community, you would be more apt to buy the stock.

After reading the annual report, proxies, conference calls, and presentations you should have a pretty good understanding about the business, the markets perception of the business etc. You now need to do your comp work. And I do not mean build a comp sheet.

Where do you get your comps? A lot of the good ones are in the proxy. In DRI's case, in the 2008 proxy, on page 43 of 84 of the PDF document, the company lists its peer group. I then go in and add my own (and maybe take out a few I do not find appropriate). For example, Cheesecake Factory (CAKE) is not on this list. I'd add it in. This is where you start making calls. Lots of them. While you could go back and read every one of these companies 10Ks and proxies and conference calls if you had all the time in the world, you just do not have that much time if you are new to the situation. As an aside, that is why I believe people with industry expertise in portfolio management have a substantial edge.

Back to the due diligence calls. I will call each one of these competitors that I find relevant and talk to the investor relations department and hopefully the CFO about the business in which I am studying. Darden, being a chain restaurant, there are so many questions you could ask that would give you great insight about the inner workings of the business. I might ask Bob Evans Farms how guest counts and average check size is trending in certain markets that DRI has a big presence in. I may ask Kohl's how store closures in strip malls is affecting their business and the business around them. I may ask Zales their thoughts on mall traffic. I'd ask McDonald's what they think is happening with minimum wages in Congress. I might ask each of these companies their thoughts on the chain food business for the next three of four years and how the competitive dynamic is shaping. I'd ask each of them what trade magazines are relevant and then try to read some information on the industry / trade on the web.

You get the picture. You want to get insights into the business in which you are examining and insights into the strengths / problems the market is focusing on to exploit diversions between reality and opinion. I am telling you, less than 5% of buy side professionals do this. Why? Maybe they are too busy building excel models or maybe they believe Investor Relations' job is to blow smoke up every one's ass. I don't know. If you are smart about it, you can get good information from these people.

So now you know a fair deal about the business, the industry, what is going on in the real world. From here it depends on the company being analyzed. You want some real on the ground, scuttlebutt research. For DRI, I may call 10-15 different restaurants and chat up the hostess or manager and get some information about what is going on in the stores. How has business been? What's new to the menu? What are customers liking? Etc. For other businesses, I may call direct competitors or maybe even suppliers to get the same sort of information.

At this point, you should have a pretty solid opinion of what is going on in the business. At this point, I will throw together a few excel spreadsheets. The first will be a model (with some historical included) that will have three or four drivers. At this point, with all your due diligence, you should know the drivers. If not, go back and call the competitors and figure it out. You want to compare your thoughts on the drivers with the market assumptions. If you do not know the markets assumptions call up sell side analysts and ask. For DRI, here is the Darden analyst coverage. You do not want to call up analysts and ask their opinion. You are smart enough to form your own opinions. You talk to them to get factual information that you may have trouble getting and for figuring out where the market expectations are. So you have your model, with your drivers, and then you compare it to the markets assumptions and drivers. For example, the consensus EBITDA for FY2010 for DRI is $959M. If your model comes in materially lower than that you would be biased on the short side.

Unfortunately, that is not the only step. How much of this is already priced in? Maybe everyone know the analysts are wrong and that is priced in with low multiples. So now we do our multiple work. I want to compare the multiple to those direct competitors on a current basis, but also on a historical basis. What is the lowest a restaurant similar to Darden has ever traded for? What is the highest multiple ever traded? What is DRI's highest EV/EBIT multiple ever (on a normalized basis)? What is the lowest cash flow multiple it has ever traded for? Etc. If you find a stock where your expectations are significant lower than the market, and the stock is trading at a relatively high multiple to its competitors and its historical range, well that is just a beautiful thing.

You will want to establish a target. We will talk about how we do that on the long / short side in a future post. Also, you want to see if the common stock is the best way to go...maybe you buy the CDS (trading at ~150bps) to get short the company. Or maybe you want to hedge yourself and go long bonds, short common. Again, a great subject for a future post.

This is the general undertaking I do with most common stock investments. Certain situations call for different due diligence practices. I may go further down the rabbit hole for some stocks and less for others. Nonetheless, I love the process. Each time I do it, I try to get better. And each time I learn about a company, I have more information for future investing opportunities.

Distressed Debt Exchange - GM

I know we have been pounding the topic of Distressed Debt Exchanges into a pulp on this blog.  But there is a reason for that. They are going to be happening with such frequency in the coming years as levered entities try to "solve" their problems with a coercive exchange (one defined as threatening Chapter 11).  The big news this morning is GM's Debt Exchange. You can find it here: GM Debt Exchange.  I just finished reading the exchange offer.  Here is an executive summary of the press release:

• Commencing exchange for $27B of unsecured notes
• Exchange is vital to restructuring out of court
• 225 shares per $1,000 of bond principal.  
• Cash will be paid out for accrued interest. According to the press release, USD interest accruals range anywhere from $7.5 per $1000 bonds (less than a 1 point) to $43 per $1000 bonds (4.3 points)
• If GM does not receive enough exchange by June 1, 2009, will file for bankruptcy
• Exchange expires 11:59PM, Tuesday May 26th
• Inserting a call option on non-USD notes
• Consummation is conditioned upon: Treasury approval (they believe they need 90% of principal to tender to get approval), U.S. Treasury issued 50% of pro forma common stock in exchange for cancellation of at least 50% of GM's outstanding treasury debt and cancellation of the Treasury Warrants, evidence that the Treasury will provide an additional $11.6B of funding that GM believe it will need after May 1st, 2009, VEBA modification (discussed more below), U.S. Treasury and VEBA ownership not more than 89% of Pro Forma stock, binding labor modifications.

Note holders will get 10% of the new GM, existing common will get 1%, and the Treasury and VEBA the balance (exact ratio to be determined). The VEBA negotiations call for GM to issue stock instead of cash for at least 50% of their future obligations to the VEBA (the balance paid in cash).

Bonds are currently trading somewhere around 9 bid, 10 offer. Maybe slightly higher for more liquid issues. The Revolver is trading 50.5-52.5, up a few points from Friday's close, and the Term Loan is trading at 61 bid without, up 3 points from Friday's close.  Obviously the secured lender are liking this deal. The stock is also up - I do not know why though. 

This exchange offer is significantly worse for bondholders than the one being discussed a few weeks back where debtholders would get a substantial portion of the equity. According to press releases, the GM break even point for SAAR would be 10M. Of course, the company is saying this, and you can make your own decision if you want to believe what GM is telling you. 

There was other news on GM today (cutting lots of jobs, phasing out Pontiac, speeding up closing of factories, cutting dealerships by 34%). For more details on these read the WSJ piece

Admittedly, I have nothing positive to say about this plan.  GM should of filed years and years ago.  They've spent ~$145B in capex since 1990 ... AND THEY STILL NEED MORE MONEY TO SURVIVE. They are still going to have 40,000 unionized workers. They are still going to need more tax payer money. They are cancelling tax payer debt in exchange for stock. 

As a bondholder, I really do not know what you should do. If they file, the government is going to surely prime you, and your recovery could be less than ten cents on the dollar where the bonds are trading. The exchanged stock though - how much is that really worth?  I'd be a seller of the bonds at these levels.  I don't want the stock, and I do not like the risks that a bankruptcy brings.

This whole situation is a damn shame.

Distressed Debt News Weekly Round-Up

As noted in this post, Distressed Debt News, we are going to try to provide readers a short summary of some of the happenings and news in distressed debt world. This list if far from comprehensive as distressed news is a hot topic these days, and I expect coverage to increase as the default rate continues to climb throughout 2009 and 2010. Some other people do too.

If you have any tips or news stories regarding distressed debt, email me at hunter [at] distressed-debt-investing [dot] com.

Distressed Debt News - Week Ended 4/26/2009

• Quebecor (US) Files its Chapter 11 Plan and Disclosure Statement: Under the plan, unsecured creditors are getting back notes for up to 50% of their claim as long as total claims in that class do not exceed $150M. Secured creditors (revolver and others) are to receive some combination of stock, cash, and preferred stock. The bond holders are to receive new common stock and warrants. A hearing is set for May 15th regarding the plan and disclosure statement. You can read the disclosure statement here: Quebecor Disclosure Statement
• Motor Coach Industries Exits Chapter 11: Motor Coach received $230M in financing to emerge from Chapter 11. Motor Coach, a bus manufacturer, paid off its pre-petition first lien lenders with debt borrowed from the reorg, paid off its 2nd lien with a rights offering, and converted the third lien into all of the new equity. Debt was reduced by $300M. Affiliates of Franklin Mutual (Michael Price's old firm) are now the controlling shareholders. The bankruptcy docket can be found here: Motor Coach restructuring information
• Hayes Lemmerz in Talks with Creditors: Auto supplier Hayes Lemmerz is in discussion with its creditors. Yet to file its annual report, Hayes is in a tough spot given what is going on with the domestic automarkets. If anyone is following this situation closely, please let me know
• Masonite Schedules Confirmation Hearing: Masonite has scheduled its confirmation hearing for May 29th. The prepackaged plan was filed on March 16th. I am going to do a write-up on Masonite in the coming weeks. For a quick summary on the plan, see this press release: Masonite Restructuring Plan. Here is the docket: Masonite Docket
• Eurofresh Files for Chapter 11 Protection: A producer of tomatoes, Eurofresh filed for Chapter 11 on April 21st in the U.S. Bankruptcy Court of Phoenix. There is $180M in Senior Notes, ~$40M of sub notes, and a ~$55M Term Loan. The Chapter 11 was prepackaged with the plan to convert $210M of debt into equity with an infusion of $10M of capital. Here is the bankruptcy information: Eurofresh Docket
• Broder Brothers Threatens Chapter 11 is Bondholders do not Accept Exchange Offer: As we discussed in Distressed Debt Exchange Offers, distressed debt exchanges are becoming more and more popular. In Broder Brother case, the company is trying to solicit a 98% approval for an exchange that would give old bond holders new stock plus $444.44 in new notes for each $1000 of old notes they own. Kirkland Ellis is the legal advisor and Miller Buckfire is the financial advisor.
  
• Emmis and Barrington Broadcast buy back debt at a discount: In an interesting trend, Emmis and Barrington bought back their term loan and bonds at a discount. Barrington bought over 1/2 of its existing senior sub bonds at a massive discount. The purchase was funded by an equity infusion from its sponsors. Emmis, a radio station owner, held a dutch auction to purchase some of its bank debt back. This is an interesting development as generally bank debt holders want their loans to be paid back at par. But I guess for certain funds and CLOs, getting back cash instead of going through a protracted bankrupty makes sense.
• Spectrum Brands sets June 15 Confirmation: I have been following the Spectrum Brands bankrupty case for a while. It is a fascnitating one. Why? Generally speaking I see Spectrum Brands as a global business that will eventually come back. It's issues are one of high debt loan and cyclicality. Once the high debt load is gone, and the market for its products come back, a lot of money can be made by buying the debt on the cheap. This was originally a prepack - but bank debt holders do not like the plan in its current form. And frankly, neither do I. I believe too much debt was going to be reinstated and that bond holders were getting more than they deserve. Here is the objection, which is an incredible read. For more information here is the docket: Spectrum Brands docket
• Other News That I haven't gotten time to go over: Star Tribune, Objections to the Charter Plan, Asarco stalking horse bid, Spansion, SGLP, Home Mortgage Cram Down Bill, Tronox, Chrysler (which we will be sure to report on early next week).
  

Following a Bankruptcy Reorganization: Dayton Superior

One of the keys to successful distressed debt investing and the foundations of good distressed debt research is following the bankruptcy reorganization process. As we talked about in our analysis of Idearc, we like to review the first day filings to be acquainted with the situation.

In reality though, a hedge fund investing in distressed debt will have been following the situation for quite some time. Maybe they own bonds, or maybe they are waiting to see how the situation plays out. The analyst at the fund will know the company, will have probably talked to the advisers, talked to other hedge fund or institutional investors, and at this point probably already made a decision.

Other times though, things just kind of fall into your lap. You haven't been following the company, in fact you do not know anything about the company at this point. All you see is something like this:

"XYZ Company Files for Chapter 11"

From that point, where do you start?

Well I am going to attempt to walk you through that right now using an example that I just pulled up.  The company is Dayton Superior. As of earlier this week, I knew nothing about Dayton Superior.  The headline was:

"Dayton Superior files for Chapter 11 protection"

And for those following along at home, here is the link to the Associated Press release: Dayton Superior AP release

I read that press release, and here are some things I take away from it:

• Dayton Superior makes products used in concrete construction
• The company received $165M in financing
• It tried to restructure outside bankruptcy but couldn't because credit markets are in such bad shape
• GE is providing the DIP, which will replace the existing $150 credit facility
• Filings occurred in U.S. Bankruptcy Court, Wilmington, Delaware

Ok. At this point we have about a 50,000 foot view. We still know nothing about the company, why it filed, what is happening at the company etc.

The next step: Google.  I Google'd "Dayton Superior" to finds the company's home page. I click around to find investor relations. Eventually we will come back to the home page to learn more about the company (an often under-utilized tool by buy side and sell side professionals alike). 

Again for you following at home: Dayton Superior's Investor Relations

At this point, I can go two ways.  I can start reading the 10k and the company presentations. Or I can dive right into the bankruptcy filings. It all depends on your poison. I personally like to dive right into the filings. I click on the "Financial Restructure Information" link, and start looking for a more detailed press release, and I find it here: Dayton Superior Detailed Chapter 11 Press Release

From this press release, I take away a few more things:

• A more detailed explanation of what the company does: "...the leading North American provider of specialized products from the nonresidential concrete construction market."
• The DIP is $165M - 12 month maturity
• The company is seeking approval for the DIP (DIPs are hotly contested in the courts)
• The company is going to attempt to fulfill its employee, customer and supplier claims
• 2008 Operating Income was $45M of Net Sales of $476M. Sub 10% EBIT business. Tough. And that was a record!
• Bid activity up 20-30% due to the Federal infrastructure initiatives. Makes sense
• Liabilities include $161 in principal and accrued interest on the company's 13% Senior Subs due 2009 and $222M in borrowings outstanding under their senior secured credit facility
• And then a very detailed business description.

The next thing we do, is look for something relating to court documents or claims information. Found it: Dayton Superior Bankruptcy Docket

I click on the court docket link on the left navigation bar, to pull up the actual docket. This pop-up window is fairly self explanatory. We care about the dates, and the court docket number (as you see Court Docket #1 was the actual Voluntary Chapter 11 petition), and then subsequent filings increase in number. I worked on the Enron case and trust me, that docket number can get pretty large. Next to the docket number is the Document Name.  

Do not let the document name scare you. Generally they are pretty self explanatory. Lots of them in the first few days of the case relate to the First Day filings, Notice of Appearances and Motion to Admit certain individuals to sit in and speak on their clients behalf, etc.

If you remember, we always like to read the affidavits or declarations in the beginning of the case. In this case, the we find it at Document #16, Document Name: "Declaration of Edward J. Puisis Support of Chapter 11 Petition and First Day Motions."  Let's read through that, and see what we find:

• Edward Puisis is the CFO of Dayton Superior 
• More business description: "The Debtor manufactures, markets, and distributed specialized products consumed in non-residential concrete construction..." You can read that part yourself
• 1104 employees, in which 325 are employed by collective bargaining agreements (unions)
• The corporate structure: Simple, one subsidiary, Dayton Superior Canada, which is not subject to any bankruptcy filings at the time. In general, if a U.S. subsidiary files for bankruptcy, many times the foreigns subs will not file.
• Pre-petition capital structure: $100M Term Loan, secured by substantially all the assets with certain priorities detailed later in the document. $103M outstanding at the filing date. $150M Revolver, secured by assets with priorities detailed below. $110M outstanding as of filing date, and ~$9M of Letters of Credit.
• The Term Loan and Revolver are governed by an intercreditor agreement that dictates collateral preference. Specifically, the Revolver has a first lien (claim) on working capital and a second lien on other portions of the as defined "Prepetition collateral." The Term Loans on the other hand, have a first lien on all prepetition collateral other than what the revolver has a first lien on (think PP&E) and have a second lien on the Revolver collateral. I know confusing, but just know Revolver = First on Working Capital, Term Loan = First on PPE. 
• Senior Sub Notes: $170M at 13% due 2009. Unsecured and subordinated. $161M outstanding at filing date. 
• Why the company filed?  Term Loan and Revolver were supposed to mature in March 2009. Tried to remedy the problem with a refinancing or sale of the company. Started negotiating. Couldn't reach a consensual solution regarding a out of court restructuring and then started negotiating a prepack. 
• While they did agree to extend the original maturity to April 20th, unable to reach an agreement of the form of the prepack
• While negotiations were going on, the trade creditors (i.e. people selling them suppliers) started demanding cash up front and accelerated payments.  This is why companies file for bankruptcy: They run out of money. To top it off, their Spring season is one of the busiest requiring substantial working capital investments.  Up against the wall, they filed for bankruptcy.
• The document then goes on to list the first day motions. I am going to talk about these in the next post, as they are quite extensive.

At this point, we have a decent understanding of what is going. Let's see if we can find some more interesting information from the docket.

I want to read all the declarations and affidavits initially.  In this case we see a few.

The first is the declaration of Mark Hootnick, a Managing Director at Moelis (a restructuring firm), in support of certain first day motions, specifically the DIP and the granting of adequate protection. This is an important document to read. One thing we take away is that Oaktree Capital Management, a very reputable hedge fund, is a significant holder of the Senior Sub Notes.  We also learn about the negotiations that went into forming the DIP.  The GECC DIP was finally chosen which as stated above will be $165M. $100M to repay prepetition Revolver obligations (which interestingly enough, GECC is the provider of), plus $35M for general corporate use. The remainder will be available upon the final Court order approving the DIP as revolving loans.

As mentioned above, DIP loans are hotly contested. Why? Because the more senior debt you layer in the worse the recovery for junior creditors. Initially the court will approve an interim DIP order, and then their will be arguments and fighting in the court until something is finally settled.

From here, now that we have a good understanding on what is going on, we need to due some company due diligence. Here are some links to get you started:

Dayton Superior - Oppenheimer Conference Presentation, Oct 3, 2008

Dayton Superior - DB Presentation, Sept 24th, 2008

Dayton Superior - 2008 10K

And it will probably help to know that the bonds are currently trading at in the upper 60s.

This will be an interesting distressed debt investing case to follow. In future posts we will examine credit agreements, covenants, DIP Terms, and a whole lot more to help you better understand distressed debt investing and distressed debt research.

The Rise of Empty Creditors?

Bankruptcy investing and distressed debt investing is a difficult and complicated process. Creditors and debtors usually have different motivations for their actions. Different creditors have different motivations for their actions. Some creditors like to take back equity to gain control of the company; others (like CLOs) want reinstated debt. Other want the company to be liquidated and to receive a fat dividend. Debtors generally want to stay alive. If management can hang onto their seats, they can be granted cheap options on the reorganized stock at the expense of other creditors. I have seen very few cases where a management walks into the court and says - "Judge, I want to liquidate." It just does not happen.

In summary - always, always look to incentives of various stakeholders.

Daniel Gross penned an interesting piece for Newsweek entitled "The Rise of the 'Empty' Creditor" Generally he brings up some fair points, unfortunately I have to disagree with him on a few others.

For those that are experienced in the CDS market, please skip this paragraph. From those that do not play in the CDS market on a regular basis, there are certain trades investors put on to exploit perceived mispricings in the market. One of these trades is a basis trade. Now there are many different flavors of basis trades, but for this post, I am focusing on one in particular. In essence, one buys credit protection, as well as the underlying bond to capture a point or yield spread in the underlying entity. For example, at one point in the not too distant future, you could buy Neiman Marcus bonds at 60 cents on the dollar, but credit protection at 25 points up front and capture a positive spread (i.e. the bonds were paying a higher coupon then the CDS insurance carry). In essence, if Neiman Marcus filed tomorrow, I should make money on that trade.

Why? If the CDS auction goes off at 30 points (meaning, those who sold protection owe 30 points to the buyers of protection), the bonds theoretically should be worth 70 points (CDS Points Up Front + Bond Price should equal 100). I make money two ways on that trade. 1. My bonds move up 10 points and 2. My CDS widened another 5 points.

Now the next question you are going to ask is: why doesn't everyone do this? Well, a lot of people do this trade - unfortunately, the market gets wacky sometimes. Especially in the illiquidity that is distressed debt securities. You can lose billions and billions of dollars (on a mark to market basis) like Deutsche Bank did last year.

In the example above, I am indeed preserving my economic interest in hope the company to fail. More importantly - I am preserving my investors economic interest. Do I not have a fiduciary duty as an investor to generate the highest risk adjusted return for my investors?

The main point I take difference with in Daniel Gross' article is his take on Six Flags. We profiled Six Flags' debt in an earlier post. I completely disagree with his notion that bond holders (like Fidelity Investments) accept the tender offer. In the tender, bond holders are only to receive 58.3% of the new stock. Who cares if they have an offsetting CDS position - as they are splitting the rest of the post restructured equity with the converts and then giving the rest to the junior claimants, who should get nothing more than warrants at best. In reality, do you really think the common or preferred'd deserve anything? If I were Fidelity, I would hold out as well until a better exchange was offered.

And the reason GGP filed was because it was massively overlevered. Not because of the CDS market. Abitibi filed because its a asset heavy, cyclical company in a secularly decling business - these businesses file for bankruptcy in times like this. And when they come out of bankruptcy, with a cleaner balance sheet, in a better economy, creditors who saw a value proposition buying their debt on the cheap in or out of bankruptcy make money.

For whatever reason, the press always seems to shift the blame to hedge funds. Why not blame GGP's former CFO and CEO for levering up at the top? Why not blame Six Flag's former management for spending over a billion dollars on capex in the last 8 or so years with -95% return to shareholders. Hedge funds don't make companies go bankrupt - poor management, poor corporate governance, and poor financial policies make companies go bankrupt.

Classic Seth Klarman

Unfortunately, I am traveling today and tomorrow and will not be able to post much - in the meantime I want to point my readers to some legacy writing of Seth Klarman.

The Baupost Fund, which Seth Klarman is President, used to file certain SEC filings during the 1990s for one particular fund of theirs. In these filings, Seth Klarman gives his thoughts on the market of the time, the investment process of Baupost, and value investing in general. The readings can be found at the link below (make sure to click the text links and read through the various letters).

Baupost old SEC filings.

I hope you enjoy.

Distressed Debt Investing Concept - GGP and Substantive Consolidation

As I begin to flesh out this blog as a site for distressed debt investing and distressed debt case studies (i.e. distressed debt research), I want to also write about certain concepts so that those new to the field can follow along with what we are talking about

Warning - this post turned into something much more complicated - I apologize in advance, but if you want to hear my thoughts on GGP read on.

The reason I want to bring up substantive consolidation is that it relates in one way or another to GGP, which, already, I get a great amount of email about.

Now I am not saying that GGP is going to be consolidated. I actually believe it will not be consolidated in the bankruptcy process because the assets (malls) are very distinct assets. In other words, I can tell Mall A apart from Mall B very easily because they have their own records, own physical assets, etc. Further, the fact that Rouse has its own financial filings (as an exhibit in GGP's 10Qs and 10Ks...Exhibit 99.1) gives me more belief that the chance of substantive consolidation is small. If GGP were liquidated, something I consider a remote possibility, substantive consolidation would make more sense.

In short, substantive consolidation is the merging of assets and liabilities of a debtor into one big pool where creditors look for recovery. In principle, by consolidating units (i.e. disparate corporate entities, divisions, malls, etc) a debtor is essentially simplifying the process of how it will settle with all its creditors. In a substantive consolidation, certain parties are helped and certain parties are hurt.  If a better capitalized subsidiary with better assets is consolidated with a worse capitalized subsidiary with more debt, the lenders to the former subsidiary get hurt - the assets they were going to get to get their loans paid off now are in a bigger, more toxic pool.  Read this for more legal info: (Bulletin):

I will not go into detail the tests the court uses to determine if the path of substantive consolidation is followed.  The simplified version:

1. Did the creditors or lenders deal with the entities as a single unit?
2. Are the affairs so entangled that consolidation will benefit all creditors? I.E to avoid harm and realize some benefit.

So in relation to GGP, and Test #1, did a mortgage lender of a mall in Iowa look to the financials of a mall across the country in extending credit?  Of course not. The mortgage lender of the mall in Iowa looked to the financials and asset coverage of that mall relative to the loan he or she was granting.

Now the reason I bring this up is that I have seen a number of people applying a cap rate across GGP consolidated NOI, subtracting the debt, and coming up with some sort of equity value. Unfortunately, and solely in my own opinion, that is not how it's going to work.  You have to break GGP into two entities: Rouse and GGPLP LLC, as well as GGMI (which was not filed).  You then compare each of these entities values to how much its on the hook for, distinct andseparate from the other entities, to see if value eventually flows to the GGP shareholders.

As an aside, if a reader thinks there is indeed equity value, why would you not buy the convert, which I believe to be trading at 10 cents on the dollar? Same entity as the common for all intents and purposes, and has $1.55B of contractually seniority to the equity. 

Nonetheless, I digress. Let's get back to some distressed debt research.

Rouse's 2008 NOI, after stripping out the land sale business, is approximately $860M.  There was ~$9.7B of mortgage debt and bonds at year end, and $2.241B are the the five remaining corporate bonds issued under two distinct indenture (1995 and 2006). So that means, there is approximately $7.46B of Rouse mortgages outstanding on 12/31/2008. And of course, things could have changed, since then.  Assuming those mortgages are worth par, the bonds, which are currently trading at 40 cents on the dollar, are implying a residual value of $900M to the bondholders...or a total distributable enterprise value of approximately $8.36B ($7.46B of mortgages at par + 900M of market value of bonds).  Which on the surface, is slightly over a 10% cap rate, exclusive of other assets and liabilities. Probably fair given we are using 2008 NOI. 

Talking to some market participants, people are assuming a 10% drop in NOI...or around $775M of run rate NOI.  At a 9% cap rate, that gives us an EV of $8.6B translating into a bond value of 51 cents on the dollar.  Add in cash generated during the bankruptcy (I doubt they upstream cash to GGPanymore), less fees, and you can comfortably come up with a valuation around 55, plus or minus 5 points.  

If you think cap rates are going to turn out to be a lot less than 9%, then you would be buyers of these bonds.  I, unfortunately, think we have a massive oversupply of malls right now with no natural buyers and tend to err on the conservative side.

This analysis though, unfortunately, is so simplistic as to be laughable.  Why? Rouse has a lot of assets. Many market participants would classify their malls as significantly better than GGPLP LLC's malls. On the balance sheet, excluding the NOI producing properties and intangibles, and including developments in progress, there are:

• $476M of developments in progress
• $1.471B of loans to/from unconsolidated affiliates
• $1.698B of investment in land and land held for development and sale
• $25M of cash  
• $154M of AR
• $135M of Deferred expenses
• $606M of prepaid expenses and other (these consist of a litany of things which admittedly I am having trouble to value)

As we noted in previous posts, and in distressed debt investing in general, we have to figure out what this pool of assets is really worth. The big chunk of assets which comprise of loans to JVs and investment in land...well that probably is not worth all that much.  Does anyone think there are going to be big buyers of land in the coming years?  And loans to JVs? Many of these loans in the industry were granted at an LTV of 75% on a 5% cap rate.  There probably is some value, but until I see a detailed schedule it would be tough to pick a number.

Unfortunately, it becomes even more challenging when you add in the liabilities outside mortgage debt and bonds:

• $860M of Deferred Tax Liabilities
• $570M of AP and other accrued expenses
• And who knows how the Howard Hughes agreement is going to be handled (if you don't know what that is, well, read the GGP 10K again).
• And very important: taxes on proceeds from asset sales

So, we are at a standstill.  Until I have more information on each of these assets and how the liabilities will be treated in bankruptcy (especially the tax ones), I cannot in good faith get excited about these bonds at 40.  Assuming a 55 cent recovery in two years, translates into a 17% IRR - in my opinion low given all the risks and uncertainties.  At 30, where the Rouse bonds were trading a few days before the bankruptcy, well, that translates into a 35% IRR. I applaud all those that bought those bonds there.  Fantastic call in my opinion. 

Where does that leave us on the GGP equity. Well in short, I am still working through it. A cursury view: As my analysis above shows, I do not think equity holders will see much value coming from the Rouse subsidiary.  GGP's NOI ex Rouse is approximately $1.75B ($2.6B per the supplement - $850M Rouse NOI). Lop of 10%, run rate NOI of $1.575B.

According to the declaration filed on the first day, GGP group had $27.3B of prepetition debt (including JV debt).  Netting out Rouse, this leaves us with $17.6B of debt at GGP standalone. ($27.3B-$9.7B).  On the surface, vs a $1.575B of run rate NOI, implies to receive any recovery to the equity holders, cap rates must be below 9.0%. Unfortunately, GGP standalone does not have the benefit of substantial ancillary assets that Rouse does.  They have some, but more worrisome is the liability side...i.e. $1B of accounts payable, accrued expenses, and lots of "other liabilities." (see the 10K for further details).  And do not forget bankruptcy fees, taxes from asset sales (if they decide to sell any malls), the DIP, etc. 

So I would say you would have to have a pretty strong opinion on cap rates below 7-7.5% to get excited about the equity - possibly a lot lower really.  The bank debt is in the 20s, the Rouse bonds at 40 and the converts are trading at 10ish, so a lot of people do not think GGP's equity has value.  In my opinion - there is no margin to safety in the equity investment. Like all investing, distressed debt investing is value driven.  The first rule is not lose money. Unless you can show me otherwise, I would rather play in the Rouse bonds (which I believe Pershing Square is also a holder).

*Update* Neil, a commenter, and no doubt in the industry, brought up the argument that unsecured creditors and equity are effectively "long calls on the mall." I agree with this argument, though I have to point out that a number of the malls (Fashion Show, Shoppes at Palazzo and a few others), are recourse to the larger entities. Further, due to the 2008 Secured Portfolio Loan facility, GGP, GGP LP, GGPLP LLC are on the hook for $875M via a guarantee. I have an old version on a detailed listing of all of GGP's malls that a Sell-Side firm put together. They estimated mall 2007 NOI at each mall. I applied a 7.5% cap rate to all the malls (including JVs) and subtracted the debt at each mall. If there was negative value, I gave it 0 weighting and if it was positive I gave it full weighting. This came back with a "long the call" value of $6.6B, on 2007 NOI and a 7.5% cap rate, which I think is generous. Now I know this is simplified because I have not broken out the various debts per subsidiary (i.e. Rouse vs GGP LP), but according to the first day filings, these claimants are ahead of you:

• $225M of Goldman Sachs loans 
• $875M of guarantees from the 2008 Secured Portfolio Facility
• $1.55B of converts
• $2.25B of Rouse Bonds
• $1.99B of Term Loans
• $590M of Revolver borrowings
• $206M of Junior Subs
• $900M of Fashion Show and Palazzo Debt
• $95M Oakwood Loan
• Some other amount of undisclosed guarantees on a few other malls (pg 17 of Mesterham's declaration)
• And the DIP.  But let's leave that out for now as they will generate cash throughout the bankruptcy.

That aggregates to $8.7B. Let's take out the $875M of the Secured Portfolio as I've included that above, leaves ~$7.8B. And I still haven't included any of the operating debt, legacy tax liabilities, bankruptcy fees, or taxes on asset sales... equity still underwater unless you can show me another $1.2B+ of assets I am missing.

As this post shows you, and as further posts will show, lots of variables and assumptions go in the beginning innings of a bankruptcy case and distressed debt investing. As the bankruptcy process takes hold, plays out and asset and liability values can be more readily discernible, market participants can become more confident in their security selection. This is why there are so many inefficiencies in distressed debt investing - they are complex situations (i.e maybe half the people that started reading this post actually finished reading it), but for those that work hard - one can get a serious information advantage and make an educated guess when the odds are surely in your favor.  Stay tuned for more thoughts on distressed debt investing.

Distressed Debt News Weekly Round-Up

Each week, I am going to attempt to provide readers with the most pertinent bits of information and happenings in the distressed debt world. My sources for distressed debt news range from trade publications to my Bloomberg. One of the keys to distressed debt investing is staying on top of what is going on in the courts and in high yield. In most situations, I will provide a link so readers can further explore the story on their own.

If you have any tips or news stories regarding distressed debt, email me at hunter [at] distressed-debt-investing [dot] com.

Distressed Debt News - Week Ended 4/19/2009

• GGP Files for Bankruptcy: As outlined in this post, GGP Bankruptcy, GGP filed for bankruptcy this week. First day motions were customary in nature, with the big news being Pershing Square's involvement in the DIP financing. In my opinion, Pershing Square's equity position was much more a negotiating chip versus an outright long position. The DIP terms are exceptional from Pershing Square's standpoint, especially the interest rate and the fact that they will receive 4.9% of the reorganized GGP (including, 4.9% of certain subsidiaries, which if I am not mistaken, believe to mean Rouse in the chance Rouse is re-organized into its own seperate company post plan confirmation - something I see as possible given the distinct debt structure and guarantees vis-a-vis Rouse and GGPLP LLC).
  
• AbitibiBowater Files for Bankruptcy: Newsprint and paper products producer AbitiBowater filed for bankruptcy this week. Filing in both Delaware and Canada under Chapter 11 and CCAA (Canadian Reorg Bankruptcy Law), AbitibiBowater concluded that no other alternatives presented themselves and determined bankruptcy was the best course of action. At some point in the near future, we will do a post about this company as its corporate structure is complicated and will provide a fantastic learning experience for our readers. Information on the U.S. docket can be found here: AbitibiBowater Bankruptcy Information
• MGM's Possible Restructuring: As reported throughout the week, MGM bondholders are licking their chops about a possible debt for equity exchange. Press reports indicate that Carl Icahm and Oaktree Capital Management (working independently from one another) are pressuring the company to file for bankruptcy. From a quick glance at some filings it looks like MGM's big issues are 1. Financing the remainder of CityCenter and 2. The credit agreement maturing in 2011. Admittedly, I have not followed this situation as close as I would like (someone else here covers it). If you are following this situation, and have thoughts or a valuation model, please contact me (email address above).
  
• Six Flags offers Debt Exchange on Certain Bonds: We first began following Six Flags in this post, Six Flags Distressed Debt Analysis. This week Six Flags, offered to exchanged $588.3M of its holdco notes, $280M of its converts as well as its preferred equity for common shares. If all goes according to plan, the straight bonds would own 58.3% of the company, the converts would own 26.7% of the company, and the preferred's would own 10% of the company, with existing holders getting 5% of the company. The company needs a 95% acceptance rate from the bond holders and convertible note holders, and if it does not get that, will look to other alternatives (read: Chapter 11). The offer expires June 25th. The bank debt looks to be trading at 74-77 post the news.
  
• Buffet Holdings Plan of Reorganization is Confirmed: For all you Old Country Buffet restaurant lovers, you will be happy to know that the company will be emerging from bankruptcy soon. The company announced receiving a total of $117.5M of new exit first lien financing which will enable the company to emerge successfully. Approximately $140M of prepetition debt will remain outstanding as second lien rollover financing. The plan or reorg estimates at 69 cent recovery for the pre-petition bank debt holders and a 4.5 cent recovery for the bond holders. I have no idea where either are really trading though. Here is the docket: Buffet's Bankruptcy Info
  
• BearingPoint seeks to sell assets to Deloitte and PWC: Bearing Point, a provider of computer services consulting, said it will sell most of its assets to Deloitte for $350M. While contended in court, the judge approved the sale. In addition, Bearing Point agreed to sell its Japanese subsidiary and commercial services business to PWC for $45M and $25M respectively.
• Other news that I haven't gotten time to go over: Spectrum Brands getting closer to emerging, the ongoing issues at GM and Chrysler, Station Casino's continuing talks with creditors, the Polaroid Liquidation, Charter, and a few others. I apologize. My one-man wrecking crew has its limits.

As I said earlier, we are going to try to have a weekly round-up of distressed debt news and bankruptcy news each week. If you have tips or thoughts or want an opinion on something, leave a comment or send me an email.

Distressed Debt Exchanges

In the past few years, we have seen an increase in the number of debt exchanges offered by companies. In short, a debt exchange offers one type of security for another at a certain price.

An illustrative example: Let's say XYZ Company has 100 million of bonds outstanding due June 30th, 2009.  These bonds trade for 20 cents on the dollar. The company has no money to speak of and isn't generating any cash flow. In order to stave off a bankruptcy, XYZ may offer to its bond holders the chance to exchange all the bonds at 40 cents on the dollar for new bonds with a later maturity.  Many times these exchanges roll subordinated debt into second lien or secured debt depending on the ability of the borrower to issue new debt in accordance with their covenants.

You may be asking why has there been such an increase in the past few years? The short answer is that much of the debt issued in 2006 and 2007 was issued "covenant lite."  My definition of covenant lite is different than what is generally reported in the press.  Most people define covenant lite as a company with no maintenance covenants, i.e. the requirement to maintain certain leverage and interest coverage ratios. But lets be honest; if a company is currently running at 4.0x leverage, and their covenant is 8.0x - that is covenant lite. So many deals in 2006 and 2007 were issued with egregious covenants that you simple had to laugh at.

That being said, these corporate debt exchanges will continue. So much leverage was put on in the credit boom that it would be impossible for companies to refinance their debt when it comes due. Do you really think anyone is going to lever up First Data Corp at 10.0x again? We probably saw peak credit (in terms of cash flow to debt multiples) in 2007 - and private equity, with the option that is the equity piece in an over levered capital structure, will do what it takes to move that option in the money.

A detailed analysis of the covenants is imperative in evaluating distressed debt. If a debtor, influenced by their private equity owners, wants to reduce debt or extend maturities via a debt exchange, and are able to under their covenants, they will most certainly do so. The problem is compounded with the fact that hold outs for these exchanges are crushed.  Why? 

1. New senior debt has been layered above them...making recovery even worse.
2. Covenants of the existing bonds (the ones the hold outs own) will be stripped
3. Significantly less trading liquidity

So, you ask...why wouldn't every borrower do this?  There are a few reasons, and one of those reasons are tax implications. If you buy back bonds at a discount, you have a gain. Gains are always taxed. Same thing with a debt exchange. The debtor will be taxed on the difference between the par value of the original bonds and the market value of the new bonds.

That was the case until February 17, 2009.  On that day, H.R. 1, otherwise known as The American Reinvestment and Recovery Act was enacted.  Under H.R.1, corporations can elect to defer this gain resulting from debt exchanges and debt buybacks until 2014, and then take their sweet time (5 years - equal payments per year) to pay off the resulting taxes. Now this stipulation is for year 2009 and 2010. So it may roll back. But I have to think, given the amount of debt maturing in the 2011-2013 period, many of company and private equity sponsors will be lobbying for an extension.

We will see a lot more distressed debt exchanges in the coming years. This is going to hurt everyone but private equity sponsors. Lenders will see their collateral diluted, bond holders will be forced to extend maturities, rogue holdouts could get crushed, and the day of reckoning, that is a Chapter 11 filing, will be pushed out again and again.