A Hypothetical Distressed Debt Interview

I mentioned to readers in the past that one of the distressed debt books they should start out with, in learning the distressed debt investing process, is Stephen Moyer's Distressed Debt Analysis. Moyer was interviewed in the most recent issue of Columbia Business School's Graham and Doddsville and I thought, for kicks, and to answer some of the emails I have not gotten around to, I would take a shot at answering the questions the authors posed to Moyer. Enjoy.

Distressed investors were touting the arrival of the next cycle as early as 2006 but to what degree did they expect it to take the shape we see today and how have the rules of engagement changed when compared to previous distressed cycles?

In 2007, Bloomberg hosted a panel on distressed debt with Marc Lasry of Avenue Capital and Mark Patterson of MatlinPatterson as the keynote attendees. It was standing room only and packed to the gills. At many of the holiday parties in 2006, for example, the Goldman Sach's Restructuring Party at the Time Warner Center, it was so crowded you could barely move. Many people saw this coming, but they didn't know what straw would break the camel's back. They were ready in 2006, and thus bought early in late 2007 ("Let's lever up senior secured bank debt at 95, at 5x") and early 2008. Little did market participants know that yields would go from 12-15% for on the run stressed names to 30-50%. They were ready and they expected it. The securitization market, that fueled credit tightening, had to slow at some point, and LIBOR + 200 was just not going to cut it for deals 5x levered through the senior tranches.

The rules of engagement have changed because capital structures are much more top heavy in this cycle than previous ones. Historically, banks like to play ball and roll their loans in a restructuring. In this cycle, I think you are going to see the fulcrum move to up the capital structure, thereby reducing recoveries at the unsecured tranches. This creates an interesting dynamic given the fundamental innefficiencies of CLO asset vs liability management in a distressed situation.

Comparing the lower volatility approach of investing in secured debt vs. the potentially asymmetric returns of buying bonds how do you think of value and rates of recovery in today’s distressed capital structures?

As mentioned above, it stands to reason that given leverage is so much higher through the secured level, recoveries on the unsecured tranches should theoretically be lower. That being said, there will be a number of situations, where, given a reasonable basis, investors moving down the capital structure makes perfect ecnomic sense. If a borrower emerges from chapter, with its senior secured bank debt reinstated at some level, let's call it 4.0x, and an investor is confident in the business prospects, buying into the junior tranches could create enormous value relative to purchasing a performing Libor + 500ish asset.

Is it a fair statement, then, to say that the fulcrum security today lies somewhere within secured debt?

All else being equal, yes. But, and I have pointed this out in the past, you have to look at motivations. If the senior secured tranche of XYZ borrowers is held 90% by CLOs, they may want to take back coupon paying paper versus equity. Now, that is not to say, that the senior secured lenders might not try to cram you down, take equity, AND paper (see: Six Flags). If I was a betting man, which I am, I would say more secured lenders will be holding re-org equity as you look through this cyle.

As for the ease of access to capital during the bubble what kind of changes do you expect going forward?

While not really prevalent now, and practically dead a few months ago, I do think you will begin to see a number of funds solely focused on the DIP game. Despite what is happening with Delphi (DIP C trading in the 30s), there is a case to be made for how attractive the "DIP asset class" is. As for more on the run financing...well, the beast is dead. Bankers will try to revive it because fees are fees, but in my mind, I do not see how the CLO model, at 12x levered, gets started again. Maybe 4-5x I can live with. With that said, a significant amount of capital has moved back to the unsecured market, where new deals are announced daily. So the tide is turning from more top heavy capital structure to a more normalized structure. A more normalized structure as compared to 2005-2007 structures would also mean less/weaker covenants with higher cash flow going out the door (to pay interest). Do those two factors offset one another? I don't know the answer to that, but it will be intersting to see how it plays out.

Given that I have been up for 16 hours working on CIT (no where near an answer yet), I'll finish the rest of the distressed debt interview over the weekend. Comments welcome.