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.