Some common terms in the distressed debt investing world

Before I begin diving into various situations on this blog, I want to make sure everyone understand some of the fundamental terms and definitions in the vocabulary of a distressed debt investor.  I will continue to add to this directory as situations become more complex.  Everyday I am learning something new as well.

Covenants:  These are ratios such as Debt to EBITDA, Total Asset Value, Unencumbered Assets to Total Assets, etc that a company must maintain at a certain level less they be "not in compliance" with their covenants.  For example, if a company has to maintain a 7.5x Senior Secured Leverage Ratio, Senior Secured leverage must be below 7.5x the company would not be in compliance with its covenants and would most likely be in default, unless they structure an amendment with their creditors (most usually lenders).   The way a covenant is calculated is spelled out in the underlying debt documents. It is important that you read these to fill in the nuisances of the various covenant calculations (for example: is cash netted against debt in determining total debt, how many add-backs are allowed, etc)

• Why are covenants important?  Covenants are the line in the sand that distressed debt investors dare companies to walk across.  If the companies do fail their covenant tests, and lenders / creditors do not wave the covenant default, the company will get on their knees and start begging for mercy or file for bankruptcy.  Now, many investors do not want a company to violate their covenants - they want the company to continue doing well and paying them timely interest and principal when it comes due.  Unfortunately, that isn't always the case. 

Forebearance / Forebearance Agreement:  Forebearance or a forebearance agreement is an agreement between creditors and a company that stipulates that the creditors will not enforce any default by the company.  In relation to "covenants" as noted above, if a company violates its covenants and thinks it just needs more time, it will enter into a forebearance agreement with its creditors.  In exchange, creditors will receive something of value, usually higher interest payments.

• Why are forebearance agreements important?  They are important because this is the period where a lot of negotiations between parties go on.  Specifically a...

Pre-packaged Bankruptcy Filing: A Pre-packaged bankruptcy filing (a prepack for short), is a bankruptcy filing that been essentially signed off on by the various stakeholders, including management and creditors. Why would a company do a pre-pack?  Because bankruptcy fees (read: lawyers, advisors) are expensive.  I am hearing right now some firms charging over $1,000 an hour for services.  A usually bankruptcy can take 12-24 months, with lots of lawyers.  Now that is a lot of capital out the door. 

• Why are prepacks important? Getting a viable company out of bankruptcy as fast as possible is almost always the goal.  If various parties can agree on a solution it makes little sense to waste time, buring capital in bankruptcy.  

Guarantors: Just like in the rental world, a guarantor is an entity that guarantees timely payment of interest and principal on behalf of another entity.  If Company A issued $100M of bonds that are guaranteed by Company B and Company A doesn't pay up, Company B is on the hook.  This is a very important concept in the distressed world and I will talk about it repeatedly. It is crucial to understand how subsidiaries guarantee holding company debt and vis-a-versa.

• Why are guarantors important? Figuring out who is on the hook for what allows investors to value how many assets support a given security.  We are trying to figure out "where the value flows."  More importantly, if two nearly identical bonds are guaranteed by different entities, their recovery in bankruptcy will be completely different.

HoldCo vs Opco: Many times in the real world, a company issues debt from various entities in its corporate structure.  For example, R.H. Donnelley issues debt from R.H. Donnelley Corp (RHDC is the symbol).  In addition, R.H. Donnelley has two subsidiaries that issue their own debt: R.H. Donnelley Incorporated and Dex Media Inc.  Further, Dex Media Inc. has two subsidiaries that issue their own debt: Dex Media East and Dex Media West.  In this example:

1. R.H. Donnelley Corp is a holding company (Holdco).  Generally equity is issued out of the holdco.
2. R.H. Donnelley Incorporated is an operating company (Opco)
3. Dex Media Inc is an intermediate holding company (Intermediate Holdco)
4. Dex Media East and Dex Media West are operating companies (Opcos)

• Why is all this important? All else being equal, opco's will have better recoveries in bankruptcy versus the holding company.  This is due to structural subordination.  The closer you are to the operating assets the better.
  

That is all for now.  I am sure this list will get very extensive in the future.  Next time we are going to examine a distressed debt investing example.